Archive for March, 2012

Off to a Fast Start

SPX Index on a yearly basis

Price Source: Bloomberg

Although we have not quite finished the first quarter, it is obvious that the broad market is off to a fast start this year. A great deal of that performance was attributable to the stellar rise of Apple shares but there has also been a healthy serving of general improvement in the economic prospects both in the US and Globally.

The question one has to ask is: how much longer can the market run?

To answer that, one must consider what is driving the market. And, in general, the drivers are generally positive and sustainable. Of particular interest is the strength in Housing and Banking for which we can take XHB (chart) and IYF (chart) as proxies. If these two related sectors are showing signs of recovery, there is hope that the great American Consumption Machine can be cranked up to its former glory.

Looking at the S&P 500 earnings breakdown, the only “fly in the ointment” is the estimate that cashflow is due to drop (down 10.9%) even though earnings are still bounding forward (up 8.8%) in 2012. However, one should note that much of the discrepancy will be due to banks writing back unused loan loss reserves (a plus for earnings but a non cash item) and increased dividend payouts (negative for cash flow but a good thing for shareholders). These are to be expected and even welcomed as the recovery slowly gathers some momentum.

Click table to see full sized

SPX Earnings Table

The forecasts for 2013 and 2014 are probably too “straight-lined” to take seriously at this point. Around half the earnings on the S&P 500 are derived outside the US so they are still susceptible to troubles in Europe or China. However, it is fair to say that most of the potential bad news appears to be in the market. It will take a serious shock event (Iran, perhaps?) to knock the markets at this point.

So, for the next few weeks, there is little reason to be concerned that the main indices have burst out of the gates a bit faster than in the past few years. The Fund King System numbers are running in the teens for most risk assets with some sub sectors reaching into the 20’s and 30’s.

The Meaning of 7.5% Growth

China recently announced that the target for economic growth has been lowered from 8% to 7.5%. For most countries, this would hardly rate more than a line or two buried deep in the middle of the paper. However, for China, the 8% growth rate is deeply symbolic. The 8% rate has been a key metric against which the Communist Party has measured itself in this latest 10 year political cycle. Anything below 8% growth is cast as the equivalent of a recession. The success of one party rule in China hinges on the ability of that party to deliver the economic goodies.

The actual number will probably come in at least 1% over or under the official 7.5% target. But all of China’s provinces and Special Municipalities are now on notice to make sure that the numbers they serve up to Beijing are in accordance with the new policy. Conspicuous bank lending to property developers is no longer in the cards.

Looking beyond China, how does this downgrade impact markets around the world? The immediate knee jerk reaction is negative but it will be interesting to see if investors can shift their mindset from the immediate aftershock of the Global Financial Crisis. In 2008/2009, demand from China, India and Brazil amongst other emerging markets was crucial to sustaining overall global demand. The largest non-financial companies in the US and Europe would have suffered much more severely without the boost of emerging markets demand. Additionally, China was a major purchaser of US Treasury bonds as China sought to recycle its massive trade surplus with the US. That position has now shifted to the Federal Reserve.

Now, however, a slowdown in Chinese demand may not prove as catastrophic as it would have three years ago.

In the US, there is both slack in the economy and signs that domestic demand is on the mend. Bank lending growth, which had been moribund despite heroic efforts from the Federal Reserve to pump high powered money into the financial system, is finally starting to show the early signs of a recovery. Housing prices at this point are a lagging indicator because there is so much built up inventory both on the market today and likely to come onto market at any sign of better activity. The real issue for the US economy is whether the nascent recovery will get strangled by higher commodity prices feeding into inflation. A China coming off the boil at this point could be just what the Bernanke FED needs to keep an accommodative monetary policy running into 2013 without kicking off double digit inflation.

In Europe, the European Central Bank (ECB) has decided to take a page from the Federal Reserve and double down on their Long Term Refinancing Operation (LTRO) which offers troubled European Banks three year money at 1%. Like QE1 & QE2 (Quantitative Easing) rounds in the US, European banks have done the sensible thing and turned the money around into ECB deposits or matching maturity sovereign debt in order to catch the fat spreads at the lowest risk possible. Europe is more exposed to Chinese demand for capital goods than the US but it is obvious that Europe is heading into recession regardless. In fact, it is Europe’s weakness that probably tipped the scales and forced the China to downgrade its GDP target. So, basically, China’s growth is not the most burning issue in Europe’s capitals these days. A more pressing question is whether the ECB is complicit in an effort to drive down the value of the Euro so that export dependent Italy, investment dependent Ireland and tourist dependent Portugal, Spain, Italy and Greece can regain a competitive advantage.

So, interestingly, China doesn’t really matter quite as much as it has in the last three or four years as a global engine of demand. It will be interesting to see if the markets recognize the admittedly temporary change in circumstances.

The System numbers do not suggest a significant change in fortune…don’t let a 50 basis point cut in China’s GDP rate spook you unless you are overexposed to Shanghai luxury apartment units.