Europe Archives

January Effect

Traditionally in the US, January is a time for chasing small caps. The NASDAQ has outpaced the S&P 500 almost 7% to 4.6% so far this month. In Asia, some of the larger markets will close or be affected by the closures around the Chinese New Year Holiday. Since the New Year will be a Dragon Year, expect at least a few strong sessions when markets reopen.

What does this mean for riskier assets? A bullish forecast off the back of a January rally is a dangerous one. Right now, the positives and potential negatives suggest another volatile year.

Housing Stocks Come Back to Life

There is no doubt that the US is starting to rouse from the GFC imposed slumber. A Financial Crisis induced recession is harder to bounce back from than the more common inventory cycle recession. One consequence (amongst many) is that one traditional avenue of entrepreneurial capital (residential real estate) has not be readily available to finance new business start-ups because of falling housing prices and general bank reluctance to extend credit to the private sector. That deep freeze appears to be thawing a bit. The bellwethers of the US domestic housing market (ITB and XHB for ETFs, LOW, HD, PHM, and LEN for individual stocks) have turned up strongly. Will this be a “head fake” like the last time XHB surged from July 8th 2009 to April 23rd 2010 (+89%)? Perhaps, but with other positive “green shoots”, this surge (from October 4th 2011, +58%) may not reverse as dramatically as the last one. Given the sharp run-up and some good earnings reports, don’t be surprised if there is a correction in the coming weeks, though.

The housing sector bears watching. If entrepreneurs can unlock capital in residential housing, the Great American Job Creation Machine can crank back into gear (recent job report numbers are rounding errors compared to what they should be for a full blooded recovery).

Summer in Europe?

Unfortunately in our interconnected world, the troubles brewing in Europe still look likely to cause more heartburn in the next few months. There is little doubt that Europe has failed to sort out the sovereign debt crisis of its periphery to the satisfaction of financial markets. Credit agency downgrades only confirm what most market players have been saying for months…the sums do not add up. The next “final deal” will just be one of a series of “deals” that will see a series of painful writedowns for the banks. Bank Capital is being bolstered largely by clever accounting tricks these days. And with hedge funds buying up troubled sovereign debt and relatively cheap Credit Default Swaps, the prospect for an orderly “voluntary” haircut looks somewhat diminished. The rot is spreading from the periphery to the core and until the Germans are forced to make some hard political decisions, the rot will continue to spread inward.

So what is left for Europe? Very likely…devaluation.

In a rambling article for Bloomberg, two professors from MIT make the case that Italy is crucial to the Euro’s survival and that unlike most other European countries, Italy has a significant amount of trade outside the EU (55% of exports according to the authors). Given those two factors, a Euro trading at parity with the US dollar should help Northern Italian exporters boost exports enough to make a difference. And, since Italy boasts a massive and vulnerable bond market, any improvement should help to relieve pressure on the Euro’s long term survival as a common currency (ETF: FXE).

How will this play in the US and other emerging markets?

In the short term, it means that a summer holiday in Europe might be a great bargain. In the medium to longer term, a more competitive Europe could hamper any manufacturing renaissance in the US as a large swing in exchange rates allow German exporters to price more keenly than US Midwestern component makers (and makers of commercial aircraft). For China, the authorities in Beijing probably have enough fiscal and monetary firepower to overcome the negative effects of a Euro devaluation (the Eurozone is both a large customer and competitor of China).

One can only guess whether China will continue to diversify its foreign exchange holdings into Euros. Given the likelihood of a significantly lower exchange rate in the not too distant future, it would not be surprising to see the People’s Bank directing its traders towards other currencies for the time being. Given the massive size of the foreign exchange reserves and China’s desire to hold down domestic inflation, the US dollar is probably the only reasonable home for recycling the trade surplus (ETF: UUP).

The Rising Dollar

As we pointed out last week, the yield curve in the US dollar is just too attractive for any profit seeking financial institution to ignore. Until the trade becomes less attractive or something better comes along, expect continued US dollar strength. (DXY is the dollar index; UUP is an ETF which closely tracks the DXY).
US dollar index and UUP ETF
Source: Bloomberg

Why is the yield curve so steep?

Relative Yield CurvesThe short term (or left hand) end of the curve is anchored by government fiat (in the US through the agency of an independent Federal Reserve). Many pundits, experts and others expend tremendous resources to divine the inner thoughts of the men and women in charge of that decision. However, it does not take away from the fact that the Fed Funds rate is set by committee and not the market. The rest of the curve is determined by pure supply and demand. Will this always lead to a steep curve? No. Sometimes the Federal Reserve needs to squeeze inflation out of the system in which case, a higher than otherwise expected Fed Funds rate is decided upon. Under the right circumstances, that can lead to an “inverted curve” of high short rates and lower medium and long term rates.

Supply

On the supply side of the equation, with a US Federal deficit running well over 10% of GDP per annum for the foreseeable future, it is clear that we will not run out of US government debt instruments any time soon. Such a large and growing supply should and does fuel downward price pressure (and upward yield pressure) on the long end of the market. Those investors who fear that ever larger government spending programs will eventually lead to system wide inflation are amongst those who worry about the supply dynamics of the treasury market. When you hear a “Treasury Bear” argument which is framed entirely in terms of future supply, be careful with the recommendation because it is build upon only half the story. Supply is not the only factor.

Demand

Demand is driven by rational economic calculation and emotion.

The rational economic calculation is a long term estimate of growth and inflation rates by which investors weigh the purchase of a medium or long term Treasury against alternative investment options. Those considerations are well discussed in the market and tend to change slowly on a quarter by quarter basis. Has something fundamental changed in the last three or four weeks? Possibly. The Euro’s foundation has been show to be a lot weaker than previously expected. That doesn’t impact US treasuries directly but it does reduce the attractiveness of Euro Government Debt instruments that compete for investor attention. Right now, the biggest source of demand comes from the banks who are able to borrow at the short end rate and “lend” it back to the US Government in the form of 2,3 and 4 year Treasuries.

The emotional side is responsible for the short term moves. Emotional factors are almost always couched in fundamental terms. Sometimes those short term emotional excuses will become longer term rational economic calculations. However two things are for sure. They start out as emotions and investors often don’t realize they are reacting to emotions because they rationalize the decisions as fundamental changes in the economic landscape. Very rarely will a fund manager get on TV to announce that he or she is petrified by the market and plans to hide in two year treasuries for the time being. It is much more likely to hear the fund manager point out two or three recent datapoints as justification for making a mid-course asset allocation adjustment.

What are the emotional buttons today? Europe has certainly provided the bulk of them lately but one shouldn’t forget the employment figures in the US, the retail figures (both can be bundled into general “double dip” recession fears), China’s property bubble and a myriad of other worries lurk in today’s financial markets.

The Giant Sucking Sound

In the 1992 Presidential Campaign, Ross Perot warned that the NAFTA trade agreement would move so many jobs from the US to Mexico that the result would be akin to a Giant Sucking Sound. If Ross Perot were in charge of the European Central Bank, he might be hearing that sound today as European financial institutions fall all over themselves and other global players to participate in the US dollar yield curve trade. The reason we do not hear Mr. Trichet moaning too loudly is because a weaker Euro is precisely what political leaders in Germany, France and Northern Italy want to see. From luxury goods to machine parts to wine, cheese, ham and sports cars, Europe’s exports will receive a nice short term boost. With capacity utilization at 75% and rising however, the fun cannot be allowed to continue indefinitely as Europe’s banks will need to refocus on bread and butter loans. So, while it is fun to attribute some sort of deeper meaning to the Euro heading back to parity with the US Dollar, larger fundamental forces in Europe will likely remove some of the demand for US dollars when European manufacturers try to expand on the back of strong export sales.

So, what does this mean for investors?

A rising dollar means that commodities (mostly priced in dollars) are unlikely to rise soon. Part of that is the dollar price tag but another part is falling demand from the Eurozone. Oil in particular can be quite sensitive on the downside to a strong US dollar.

With petroleum products like gasoline not rising (contrary to what normally happens during the US summer driving season) and European imports on sale, expect the mushy US retail numbers to improve through Labor Day at least. Consumers won’t necessarily spend just because gasoline prices are low but if there is a sale on as well, wallets should open. Therefore, we are not surprised to see VCR and XLY in the top rankings of the system.

Will GLD perform well? Not likely. Short term Treasuries and Gold are competing for the attention of the panic stricken investor. If we toss in near term US dollar strength, the balance tips from non-yielding gold to low yielding treasuries. Of course, all of these conditions are reversible so if one sees gold correct nicely in the coming months ($800-900), a sensible investment opportunity may present itself on the next upcycle.

How about equities by region? Small caps are showing continued resilience in the US but there is not much conviction behind the trade. Large caps, as represented by SPY, are not going anywhere with a very slim preference for Value (slightly ahead) over Growth (slightly behind). Large Cap European stocks (FEZ, for example) are at the bottom of the rankings as the sovereign debt issues play out at large European banks, swamping the positive benefits accruing to the large export manufacturers. Emerging Europe is still promising as it will benefit from export driven outsourcing from Germany as well as M&A opportunities as mature European corporates are compelled to switch focus from expensive US dollar based assets to cheaper Euro linked asset markets.

Asia is a mixed bag. Japan’s equity market looks to be cooling off a bit as the Yen is the only other currency as strong as the US dollar. China is at the bottom of the list for largely internal reasons related to the unwinding of a property bubble while India is close to the top of the rankings. Other Asian markets, which are tied to the US dollar, are in the middle of the pack and can be safely underweighted at this point.