31 January 2013

Last Monday was believed to be the most depressing day of the year on the basis of the poor weather, time since Christmas and, apparently, time since giving up on our New Year's resolutions. But the equity market is getting surprisingly close to euphoria so this is probably a good time to review January's data and identify whether there's any substance to this rally, or whether it's founded on (True) Faith?

Chart 2: Citigroup surprise index turned down...

As the chart shows this is more of a lagging than leading indicator so the apparent disconnect between economic expectations and market expectations suggests that the data will start improving again soon - rather than the other way around.

Eschewing fundamentalism…

Indeed, data has only ever been half of the story for this rally. The other part has been the transitioning away from frenetic, on-the-hoof, policymaking. The year started with two key risks dominating our thinking:

  • The US cliff-to-ceiling negotiations
  • The Italian elections

Tail risks receded with the re-scheduling of fiscal horizons resulting in the fiscal ceiling negotiations have been postponed until near the new 19th May deadline; unless an agreement is reached by virtue of the two deadlines which now fall before it.

That is likely because on 1st March automatic sequestration spending cuts will kick in and by the end of March a bill will be required to continue to fund the government - generally this would result in a formal appropriations bill or a continuing resolution (September's continuing resolution expires on March 27th).

The Republicans wish to lever these two events to force a long term spending plan which will restore the union's finances. To give a sense of scale here we are talking about eliminating the budget deficit over a decade which might not sound very ambitious…but it is.

Our expectation is that these negotiations will be more bitterly contested than those that took place over the New Year. Then the debate was over tax increases with no action leading to rising for most Americans, and particularly high earners. This is a repeat of the debate which occurred at the end of 2011. In both instances, the Democrats were able to paint a picture of the Republicans as being obstructive. Furthermore their obstruction effectively involved them arguing against their fundamental ideal of lower taxes.

Under sequestration that is not the case. Spending will be cut by around $110bn per year and will begin as of 1st March provided no deal is reached. The fact that half of this is defence spending cuts may offer Democrats hope that the Republicans will back down once more, but we think this may be complacent.

Chart 4: Earnings season has kept absolute valuations 'honest'

The scope for volatility surrounding this deadline is therefore high but because of the positive earnings season valuations have retained some headroom so there need not be too much ground lost as equity risk premia fall.

Chart 6: PE ratios remain within normal bounds for crisis times (post 2009)

A headwind from fiscal negotiations therefore need only cause markets to pause for breath rather than sell-off precipitously, even after they have rallied so much in recent weeks.

Two-speed Europe…

The other source of volatility is likely to come from the Eurozone although the timing is far less certain. The 24th-25th February will see the Italian elections at which the centre-left 'Italy Common Good' coalition still remains on course to be the largest single 'party', despite attracting just a third of the popular vote. We therefore expect them to seek a coalition with 'With Monti for Italy' who may then request that the centre-right (Berlusconi) join, to painstakingly recreate the Rainbow coalition of the previous parliament.

As we have commented before, such an indecisive result would create an unstable parliament, though we doubt any of the parties would relish a return to the polls.

Potentially it creates a problem however because, while Italian reforms have to some extent addressed fiscal sustainability, competitiveness remains a concern.

Whilst some economies have taken great strides in terms of closing their competitiveness gaps, others have rather stalled. Specifically Italy and France, which have now been overtaken by most of the PIIGS1 in terms of narrowing their relative unit labour cost growth differentials. Monti's labour reforms of early 2012 have been slow to impact unit labour costs, despite unemployment rising 1.7% over 2012 (bringing its trough-to-peak unemployment rise to 5.3%).

Chart 7: The Eurozone's two-speed competitiveness recovery

France, meanwhile, has this month reached a negotiated settlement between employers and unions which creates a German-style system of flexi-security. This effectively disincentivises dismissals by allowing temporary cuts in salaries and working hours during times of economic hardship.

That such policies are being considered in France, the heartland of poor employer-labour relations is something of a watershed and ought to provide some protection. But for the moment, given their current states of labour uncompetitiveness, both France and Italy are particularly at risk from the ongoing strengthening of the euro.

Japan Currency Samurai

Some say there is a currency war going on. If there is, and Abe is fighting it, then that makes him the Currency Samurai. Staunchly conservative, nationalistic and of good breeding, he has returned to the role of Prime Minster on what is termed a landslide victory. To put that in context, the LDP won the December 2012 election with 43% of district vote and 28% of the proportional vote. This compares with 2009 when it suffered, what is termed a crushing defeat, with 39% of the district vote and 27% of the proportional vote. There is something rather mythological about Abe's spectacular mandate for change which could unravel very rapidly if the opposition were to get their act together.

Will Abe-nomics succeed?

As far as Abe-nomics is concerned, we had observed that the yen had been starting to depreciate anyway, reflecting the deterioration in Japanese fundamentals. The size of the currency adjustment has rather surprised us as the Bank of Japan failed to follow through on Abe's demands with much shock and awe. Thereafter the fiscal plan has seen some tax burden shift from corporates to consumers (via expenditure tax). Opinions are divided over whether this is the right approach, with monetarists claiming that Japan needs to rid the economy of its deflationist mindset, whilst Keynesians believe that with interest rates stuck terminally at their zero bound, only government spending can create the demand needed to return the economy to growth. Is Japan in a liquidity trap or a deflationary trap? To some extent the answer to both is…yes!

Chart 8: Japan's long standing trade decline

We have some sympathy with the idea that consumers don't consciously believe in deflation. Surveys suggest they don't feel as if prices are falling. Part of this reflects the fact that many non-discretionary items have risen over recent years. Energy costs would be an example - although the strength of the yen has softened the impact.

Whether it is consciously deflationist or not, there seems to be a Japanese savings mindset which prevails. The subtle distinction is between saving based upon the rather abstract notion that prices in the future will fall, or saving because: your income is low, your job security is low, you expect future expenses to rise, or you expect taxes to rise.

Whilst the last two of these would be consistent with diminished deflationary pressures, they would not be consistent with inflationary expectations prompting consumption.

The ability of consumers who spend the bare-minimum to schedule that spending according to expectations of prices is limited. You wouldn't stop eating this year because you expect food prices to be lower next year. The second factor is that when you have a large debt burden and a fiscal stimulus, rational consumers may expect future taxes to rise to repay that debt. Such thinking follows the broad theory of Ricardian Equivalence.

Chart 9: JPY divorces from 2 year treasury yields...

We are concerned, therefore, that inflation might not be what savings-hooked Japanese households need. That it should come so fast, as a result of Abe's talking down of the currency, risks transforming an economy which was adjusting gradually and naturally to diminished export competitiveness in currency terms and inflicting a demand shock upon it which simply resets the natural rate of economic growth, a step below its current level.

Countries with poor demographics need to increase their labour force by incentivising fertility or immigration - under normal circumstances this is a tough policy to sell. The policy is wage-deflationary but competitiveness-enhancing. Given that the desire for a weaker yen is to enhance export-competitiveness surely there must be a case for doing so by employing more, cheaper, employees. Having elected a staunchly nationalistic government the chances of Japan pursuing such supply-side measures looks pretty remote.

Having been the first of six Prime Ministers in five years who had to fall their swords, we wonder how long the Currency Samurai will last this time before Seppuku beckons…

Appendix

Chart 10: Five Year Index Returns in Local Currency and Sterling Terms

January's News…

Chart 1: Year to date performance in local currency and GBP terms (5 year returns in appendix)

US
  • Q4 GDP disappointed but was heavily skewed by the fiscal cliff.
  • Disposable income growth was far more positive.
  • Manufacturing ISM surprised positively whilst failing to break the longer term downward trend.
  • The labour market strengthened as unemployment claims made new lows, since mid 2008. Unemployment actually ticked up to 7.8% but underemployment also continued to trend lower.

Chart 3: US ISM survey sector divergence

United Kingdom
  • PMI manufacturing unexpectedly moved into expansionary territory. Services and Construction however disappointed. PMI Services moved into contraction for the first time since 2010 with the lowest reading since April 2009.
  • Manufacturing and Industrial Production were both weaker than expected setting up a sharper than expected -0.3% Quarter-on-Quarter shrinkage in fourth quarter GDP.
  • Mortgage approvals remain consistent with house prices flat-lining over the next six months. The RICS house price balance is consistent with very modest gains.
  • M4 money supply continues to recover.

Chart 5: Further stagnation in UK house prices

  • Inflation remains above target but core inflation surprised on the downside.
  • Income growth was also weaker than expected.
  • The weakness of earnings growth continued to exert its positive influence on the labour market as changes in employment surprised on the upside, jobless claims surprised on the downside and the unemployment rate fell from 7.8% to 7.7%.
France
  • The yawning French trade deficit narrowed to its tightest since French trade collapsed in November 2010.
  • French PMS services surprised negatively suggesting the sharpest contraction since April 2009. Manufacturing PMI was in-line with weak expectations.
Germany
  • German PMI Manufacturing disappointed but remains well off its lows. Services continue to flat-line.
  • Retail sales holding up reasonably well.
  • Inflation marginally above target.
  • Unemployment remains close to lows. Trade and current account holding up well. Imports and exports both equally weak. Factory orders both weak but on a recovering trend.
Spain
  • Industrial production disappointed and has been contracting since early 2011.
  • Unemployment continues to rise unabated.
  • House prices continue the decline they started in mid 2008.
  • Borrowing costs creeping higher but spreads are stable, consistent with higher global bond yields.
Italy
  • An apparent recovery in Manufacturing & Services PMIs surprised positively whilst still being consistent with contraction. Industrial Production however disappointed.
  • Unemployment continues to rise.
  • Borrowing costs tighter - outperforming Spain and the quality bond markets.
  • Retail sales weak.
  • Consumer confidence continues to slump to an all time low.
China
  • Manufacturing PMI was surprisingly strong and in expansion territory at 50.6. It is showing something of a recovery although still well below the heady heights of 53 seen in April 2012.
  • CPI came in ahead of expectations creating some fear of tightening from the authorities. Money supply (M2) however remained very weak, still consistent with a recovery but far from decisive, suggesting more deflationary pressures over the coming months before inflation stabilises.
  • The trade balance remains elevated. Both export and import growth has been tepid but imports more so.
Japan
  • Across the spectrum, from monetary base to M3, money growth indicated that change is already afoot in Japan. This notably preceded the Bank of Japan's rather underwhelming announcement of a new target and potential asset purchases.
  • The current account dipped into negative territory for only the third month since records began in 1998.
  • Machinery orders seemed to buck their downward trend while Industrial Production disappointed but was still showed the second highest December growth in a decade.

IMPORTANT NOTES
The information contained in this report represents an impartial assessment of the value or prospects of the subject matter. Graphs, performance data etc are as at the close of business on the day preceding the date of the note. The information contained in this report has been taken from sources disclosed in this presentation and is believed to be reliable and accurate but, without further investigation, cannot be warranted as to accuracy or completeness. The opinions expressed in this document are not the views held throughout Brewin Dolphin Ltd. No Director, representative or employee of Brewin Dolphin Ltd. accepts liability for any direct or consequential loss arising from the use of this document or its contents. We or a connected person may have positions in, or options on, the securities mentioned herein or may buy, sell or offer to make a purchase or sale of such securities from time to time. In addition, we reserve the right to act as principal or agent with regard to the sale or purchase of any security mentioned in this document. For further information, please refer to our conflicts policy, a printed copy  is available on request. The value of your investment or any income from it may fall and you may get back less than you invested. Past performance is not a guide to future performance. If you are in any doubt concerning the suitability of these investments for your portfolio you should seek the advice of a qualified investment adviser. Brewin Dolphin Ltd, a member of the London Stock Exchange, authorised and regulated by the Financial Services Authority. Registered office: 12 Smithfield Street London EC1A 9BD. Registered in England and Wales no 2135876.

Despite the euphoria markets are still rewarding capital discipline and punishing excess. That suggests we're still mid cycle not late cycle.- Guy Foster, Head of Portfolio Strategy

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