Despite renewed concerns that the fragile global (U.S.) economic recovery will fizzle and/or the Euro crisis will spiral out of control, the latest OECD composite leading indicators (CLIs) for February still pointed to a potential turning point in economic activity in the Euro area and regained momentum in other economies. The April US and China PMIs supported this by surprising on the upside. The pace of growth in the U.S. manufacturing sector rose in April to its highest in 10 months, suggesting the US economy is still resilient despite a disappointing Q1 GDP report.
U.S. Economy is the Most Resilient
The U.S. Q1 GDP report was weaker than expected ostensibly because growth from rising consumption and inventories was cut by lower government spending at all levels as well as a dip in nonresidential fixed investment. The April ISM index however surprised on the upside, rising to 54.8 in April from 53.4, and the details were strong, despite negative seasonal distortions. Both the new orders and employment indexes rose while inventories declined. New orders are now at their highest level since April 2011. The latest Senior Loan Officer survey also points to the conclusion that the weakness in Q1's business investment was a one-off. Structurally, US manufacturing is regaining competitiveness on a weak USD and falling energy costs with record low natural gas prices.
Thus U.S. stock prices continue to claw their way back to 2007 highs, climbing a wall of investor worry that is being ameliorated by a clear commitment from the FED to do whatever it takes to deliver on their dual mandates of stable prices and full employment, and, when necessary, averting a Euroland meltdown with USD swap lines. Interestingly, the S&P 500 is lagging the big cap, dividend paying DJI as well as the high-tech “Apple NASDAQ”. Year-to-date, the S&P 500’s relative performance has been hobbled by utilities, energy and consumer staples, in that order, while being led by financials, technology and consumer discretionary. The secular under performance of energy has come despite surging crude oil prices, given the revolution in US production of energy, particularly natural gas.
The U.S. Q1 GDP report was weaker than expected ostensibly because growth from rising consumption and inventories was cut by lower government spending at all levels as well as a dip in nonresidential fixed investment. The April ISM index however surprised on the upside, rising to 54.8 in April from 53.4, and the details were strong, despite negative seasonal distortions. Both the new orders and employment indexes rose while inventories declined. New orders are now at their highest level since April 2011. The latest Senior Loan Officer survey also points to the conclusion that the weakness in Q1's business investment was a one-off. Structurally, US manufacturing is regaining competitiveness on a weak USD and falling energy costs with record low natural gas prices.
Thus U.S. stock prices continue to claw their way back to 2007 highs, climbing a wall of investor worry that is being ameliorated by a clear commitment from the FED to do whatever it takes to deliver on their dual mandates of stable prices and full employment, and, when necessary, averting a Euroland meltdown with USD swap lines. Interestingly, the S&P 500 is lagging the big cap, dividend paying DJI as well as the high-tech “Apple NASDAQ”. Year-to-date, the S&P 500’s relative performance has been hobbled by utilities, energy and consumer staples, in that order, while being led by financials, technology and consumer discretionary. The secular under performance of energy has come despite surging crude oil prices, given the revolution in US production of energy, particularly natural gas.
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S&P Lags NASDAQ and DJIA |
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Consumer Discretionary Best L-T Performers |
U.S. Stocks Offering the Best Alpha
Anticipating a repeat of the 2009 rally in emerging markets, investors piled back into emerging market stocks, only to find that the best alpha was available in the U.S., as the emerging markets remain hobbled by weakening China growth, recessionary Europe, surging energy prices and recurrent bouts of “risk-off”. Indeed, the MSCI Emerging Markets ETF (EEM) has dramatically underperformed the S&P 500 in USD.
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Emerging Markets Significantly Lag the U.S. |
Beware the Fiscal Gap?
Yet Federal Reserve policymakers are sounding the alarm over a potential “fiscal cliff” at the end of this year, when scheduled U.S. tax hikes and spending cuts could pose a big threat to the fragile economic recovery. Along with its official mandate of watching unemployment and inflation, the FED is keeping a close eye on a potentially debilitating political fight over how to fix the budget deficit. If lawmakers in Washington do not get rid of the tax hikes and spending cuts due to take effect in early 2013, the country could careen into another recession.
Yet Federal Reserve policymakers are sounding the alarm over a potential “fiscal cliff” at the end of this year, when scheduled U.S. tax hikes and spending cuts could pose a big threat to the fragile economic recovery. Along with its official mandate of watching unemployment and inflation, the FED is keeping a close eye on a potentially debilitating political fight over how to fix the budget deficit. If lawmakers in Washington do not get rid of the tax hikes and spending cuts due to take effect in early 2013, the country could careen into another recession.
However, a revolution is underway that could transform the US economy from a net user of global energy resources to a net exporter, which we believe will cause a fundamental shift for the better in the “twin deficits” in the US balance of payments and the central government deficit over the next decade. U.S. regulator approval of the first major U.S. export facility for liquefied natural gas (LNG) is likely to trigger an acceleration of project approval requests. As new export contracts are signed with major LNG customers, Fitch Ratings expects global demand for cheap and plentiful U.S.- and Canadian-produced gas to rise steadily over the next few years.
Euroland : “Enough of the Debt Fetishism, it's Time for Proper Stimulus”
Euroland : “Enough of the Debt Fetishism, it's Time for Proper Stimulus”
Since the Euro crisis began, the mantra has been that struggling Euro Zone countries
must reduce budget deficits and carry out deep structural reforms, even as sovereign debt contagion was metasizing throughout the region as
fiscal austerity for already contracting economies created a
dangerous downward spiral that deepened fiscal deficits and further choked
off prospects for growth.
Euroland is belatedly coming to the realization that the German/IMF formula, i.e., austerity in return for bailouts, is not only not working, but is very likely exacerbating the problems of the “Club Med” states. Slowly but surely, the EU is shifting its message to promoting economic growth, pushed toward this line of thinking by the electorate of even “core” Euro nations pushing back on debilitating austerity measures by politically throwing the bums out.
Faltering economies are no longer just a problem for the Club Med states, as the Eurozone is experiencing a sharp contraction in the retail sectors of the three largest Eurozone economies – Germany, France and Italy – where sales have fallen to their second lowest level on record. The purchasing managers’ index (PMI) for the three countries fell to 41.3 in April, down from 49.1 in March, and was the weakest reading since November 2008.
Faltering economies are no longer just a problem for the Club Med states, as the Eurozone is experiencing a sharp contraction in the retail sectors of the three largest Eurozone economies – Germany, France and Italy – where sales have fallen to their second lowest level on record. The purchasing managers’ index (PMI) for the three countries fell to 41.3 in April, down from 49.1 in March, and was the weakest reading since November 2008.
The question for investors of course is whether the Euro bloc can come up with a strategy that convinces skeptical investors while keeping debt in check. So far, the pattern has not been encouraging, as EU officials lurch from crisis to crisis. In recent days, the bare bones of a strategy for stimulating growth have started to come together, with the intention of launching it at an EU leaders' summit in late June.
The main focus is on increasing the capital of the European Investment Bank, the EU's long-term lending arm, to allow it to make bigger investments in infrastructure projects and related areas across the EU's 27 member countries. The EIB financed EU projects worth around 70 billion euros in 2010, with the lending made on the basis of relatively small paid-in capital. By boosting the paid-in capital by only 10 billion euros ($13.2 billion), the bank's lending could be greatly leveraged, delivering extra investment of up to 180 billion euros. While such growth initiatives could help revive growth at the margins, but it does not look like a game changer. These amounts are only a bit more than a drop in the bucket compared to the 1 trillion Euros created by the European Central Bank - which while averting a credit crunch has done little to revive a Euro Zone economy poised to slide back into recession.
That said, shifting the rhetoric from austerity to restoring growth is a significant step in the right direction, turning the single-minded focus on austerity heretofore that only pushed the weaker countries faster down the road to hell in a hand basket. In terms of political realities, there currently is not much prospect of giving Euro members much leeway on debt, as new fiscal rules to ensure deficits are kept to a common minimum are being established. The fiscal pact is therefore likely to remain largely intact, while the path of deficit reduction will be eased. For all the apparent hopelessness of the Euro situation, Spanish and Italian bond yields are still well below the prior crisis peaks, implying that the situation has incrementally improved.
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Spain, Italy Yields Still Below Prior Peaks |
China No Longer a Sure Bet for a Growth Boost
China’s economy is slowing, but there is much debate about how far it will slow and when it will reach a new cruising speed. The manufacturing sector showed fresh signs of bottoming out in April, with export orders ticking up, but activity still contracted for a sixth consecutive month. The gap between the HSBC PMI, which is geared to smaller firms, and the official PMI, covering predominately state-owned enterprises, highlights the divergence between credit availability for state sponsored firms and smaller firms.
With softness persisting in Q2 and China export markets (particularly Europe) still sluggish, few expect a sharp rebound in China growth. The bigger issue for US, European and Japanese firms that export or produce product in China, is the loss of what had once been viewed a sure bet to goose overall growth. Further, we have seen stocks of basic materials like copper for example piling up to the point Chinese hoarders are running out of room to store.
Caterpillar's (CAT) sales in China fell by $250 million to $300 million in the first quarter, forcing the world's largest maker of earth-moving equipment to export about 20% of its China-made equipment to other countries this year. Swiss engineering group ABB reported profit that was shy of analysts' expectations due to weak Chinese demand. United Technologies (UTX), whose Otis division is the world’s biggest maker of elevators, says their business in China is off to a slow start with a Q1 decline of 9%. Finnish escalator maker Kone Oyj (KNEBV.HE) sees China growth slowing from 10% in Q1 to 0~5% in Q2. Volvo (VOLVb.ST) cut its forecast for Chinese construction equipment to a decline of between 15%~25% from a previous outlook for flat growth. Schneider Electric (SCHN.PA) noted that part of the slowdown in China was due to weaker demand from companies that rely on exports to Europe.
Chinese government measures to cool an overheated housing market have weighed on consumer and industrial demand in recent months, and Western executives are now using terms like "tough" and "mediocre" to describe the China market. There are however major exceptions like Apple (AAPL), who knocked the cover off the ball last quarter with a five-fold surge in sales of iPhones in China, Hong Kong and Taiwan.
China’s economy is slowing, but there is much debate about how far it will slow and when it will reach a new cruising speed. The manufacturing sector showed fresh signs of bottoming out in April, with export orders ticking up, but activity still contracted for a sixth consecutive month. The gap between the HSBC PMI, which is geared to smaller firms, and the official PMI, covering predominately state-owned enterprises, highlights the divergence between credit availability for state sponsored firms and smaller firms.
With softness persisting in Q2 and China export markets (particularly Europe) still sluggish, few expect a sharp rebound in China growth. The bigger issue for US, European and Japanese firms that export or produce product in China, is the loss of what had once been viewed a sure bet to goose overall growth. Further, we have seen stocks of basic materials like copper for example piling up to the point Chinese hoarders are running out of room to store.
Caterpillar's (CAT) sales in China fell by $250 million to $300 million in the first quarter, forcing the world's largest maker of earth-moving equipment to export about 20% of its China-made equipment to other countries this year. Swiss engineering group ABB reported profit that was shy of analysts' expectations due to weak Chinese demand. United Technologies (UTX), whose Otis division is the world’s biggest maker of elevators, says their business in China is off to a slow start with a Q1 decline of 9%. Finnish escalator maker Kone Oyj (KNEBV.HE) sees China growth slowing from 10% in Q1 to 0~5% in Q2. Volvo (VOLVb.ST) cut its forecast for Chinese construction equipment to a decline of between 15%~25% from a previous outlook for flat growth. Schneider Electric (SCHN.PA) noted that part of the slowdown in China was due to weaker demand from companies that rely on exports to Europe.
Chinese government measures to cool an overheated housing market have weighed on consumer and industrial demand in recent months, and Western executives are now using terms like "tough" and "mediocre" to describe the China market. There are however major exceptions like Apple (AAPL), who knocked the cover off the ball last quarter with a five-fold surge in sales of iPhones in China, Hong Kong and Taiwan.
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Shanghai Composite Heading for Break Out? |
As far as China stock are concerned, the days of discounting endless two-digit growth are behind us. That said, the Shanghai Composite has been suffering from a ex-growth slowdown going on five years, and if investors can confirm that China's growth is settling in at a new cruising speed somewhere between 8% and 7%, the Shanghai Composite looks poised for a modest rally, if only to catch up to the move during the same period in other major stock markets.
Japan Still Hobbled by Unfulfilled Promise, Serious Structural Malaise
While Bank of Japan easing last November and surprising with additional easing in February was a catalyst for renewed interest and hope that Japan had achieved some positive momentum, the sad fact of the matter however is that the overly cautious BOJ has never believed this quantitative easing thing and inflation “targeting” would ever work—not when they first introduced QE to the world in 2001, and not now, when QE has become accepted central bank policy for extraordinary times. As a result, they are always a day late and a dollar/JPY short of market (and political) expectations.
With successive Japanese governments hopelessly mired in political gridlock and seriously fiscally challenged by ever-growing government debt, the BOJ is deathly afraid of unleashing the inflationary expectations genie out of the bottle. If inflationary expectations were to suddenly trigger even a 100bps selloff in JGBs, the BOJ would go down in history as the villain who precipitated the great Japan fiscal crisis that blew huge holes in banking sector balance sheets and already seriously underfunded pension assets.
In terms of Japan’s increasingly precarious government debt situation, deflation is actually the expedient choice, as it keeps Japan’s debt monster in check even as it chokes off economic growth and slowly but steadily impoverishes Japan’s savers and pensioners. The trade-off of course is the structurally strong yen that is strangling the international competitiveness of some of Japan’s most venerated national champions—particularly in consumer electronics, where Japan’s majors have all but completely given up on successfully competing with Asian rivals in South Korea and China.
Bottom line, the BOJ is not the FED, i.e., it can't engineer a significant rally in Japanese stocks all by itself. Thus top-down calls on Japanese equities are at best "15 minutes of fame" rallies that offer relatively brief periods of global outperformance. While Japan is seen as the ultimate play on the global economic cycle, the global economic recovery is as yet too fragile for Japan's economy to surf. If anything, external demand will remain a question mark for the time being. In this regard, the investment universe for Japan is of individual stocks with attractive fundamentals that just happen to be domiciled in Japan, not a stock market.
While Bank of Japan easing last November and surprising with additional easing in February was a catalyst for renewed interest and hope that Japan had achieved some positive momentum, the sad fact of the matter however is that the overly cautious BOJ has never believed this quantitative easing thing and inflation “targeting” would ever work—not when they first introduced QE to the world in 2001, and not now, when QE has become accepted central bank policy for extraordinary times. As a result, they are always a day late and a dollar/JPY short of market (and political) expectations.
With successive Japanese governments hopelessly mired in political gridlock and seriously fiscally challenged by ever-growing government debt, the BOJ is deathly afraid of unleashing the inflationary expectations genie out of the bottle. If inflationary expectations were to suddenly trigger even a 100bps selloff in JGBs, the BOJ would go down in history as the villain who precipitated the great Japan fiscal crisis that blew huge holes in banking sector balance sheets and already seriously underfunded pension assets.
In terms of Japan’s increasingly precarious government debt situation, deflation is actually the expedient choice, as it keeps Japan’s debt monster in check even as it chokes off economic growth and slowly but steadily impoverishes Japan’s savers and pensioners. The trade-off of course is the structurally strong yen that is strangling the international competitiveness of some of Japan’s most venerated national champions—particularly in consumer electronics, where Japan’s majors have all but completely given up on successfully competing with Asian rivals in South Korea and China.
Bottom line, the BOJ is not the FED, i.e., it can't engineer a significant rally in Japanese stocks all by itself. Thus top-down calls on Japanese equities are at best "15 minutes of fame" rallies that offer relatively brief periods of global outperformance. While Japan is seen as the ultimate play on the global economic cycle, the global economic recovery is as yet too fragile for Japan's economy to surf. If anything, external demand will remain a question mark for the time being. In this regard, the investment universe for Japan is of individual stocks with attractive fundamentals that just happen to be domiciled in Japan, not a stock market.
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The Heavy Drag from Structural Domestic Net Selling |
The above table of net buying/selling by investor type shows the heavy drag that structural net selling from domestic financial institutions continues to exert on Japanese stock prices. Five years ago, net buying of the degree seen by foreign investors would have sent the benchmark indices surging. Now, this buying merely serves to keep the indices moving in the right direction, with prices crumbling once there is any slowdown in the scale of net buying. Domestic pension investors have been burned by their historical preference for top-down index investing according to market cap size, to the point they are abandoning a Topix-like portfolio for a much more focused, smaller portfolio of stock they believe can produce Alpha.
That said, selected companies in the automobile and machinery sectors are defying rumors of their demise with global class, innovative products that allow them to demand and get payment in JPY,
despite the challenges of serious interruptions to global supply chains and the ravages of a super strong JPY, Year-to-date, the leading Topix sectors have been transportation (automobiles) and machinery, ostensibly among the many sectors bearing the brunt of global supply chain, uncompetitive domestic production conditions and a superstrong currency. This means stocks like Toyota (7203) and Fanuc (6954) have and will continue to prosper. Further, other companies in the beleaguered electronics industry such as Hitachi (6501) broke ranks early and embarked on a fundamental re-inventing of their businesses, jettisoning loss-leading consumer electronics and semiconductors for “old school” industrial electronics. On the other hand, Japan's banks remain the biggest drags on any sector-diversified portfolio, partially because every stock sold from their strategic holdings of non-bank companies is reciprocated by selling of bank stocks held by these companies. What we have seen in bank stock performance over the past year only reinforces our view that Japan's bank stocks are the mother of all shareholder value destroyers.
despite the challenges of serious interruptions to global supply chains and the ravages of a super strong JPY, Year-to-date, the leading Topix sectors have been transportation (automobiles) and machinery, ostensibly among the many sectors bearing the brunt of global supply chain, uncompetitive domestic production conditions and a superstrong currency. This means stocks like Toyota (7203) and Fanuc (6954) have and will continue to prosper. Further, other companies in the beleaguered electronics industry such as Hitachi (6501) broke ranks early and embarked on a fundamental re-inventing of their businesses, jettisoning loss-leading consumer electronics and semiconductors for “old school” industrial electronics. On the other hand, Japan's banks remain the biggest drags on any sector-diversified portfolio, partially because every stock sold from their strategic holdings of non-bank companies is reciprocated by selling of bank stocks held by these companies. What we have seen in bank stock performance over the past year only reinforces our view that Japan's bank stocks are the mother of all shareholder value destroyers.
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The Banks Remain the Major Drag |