Monthly Strategy – October 2010
This months strategy is a little bit late because your favorite blogger is feeling (a bit) nihilistic in the last weeks.
We have had a nice run in September in almost all asset classes. Reasons: recent economic data is not deteriorating as fast as feared and the central bankers determination to extend monetary stimulus is stronger than earlier believed.
Decoupling theories are again in the news and in front pages. I’m not that old, but since I’m in this line of business I have experienced this two times and both time (in retrospect) people behind this theories ultimately were considered total cheats.
There are too many “this time is different” all around us.
What lies in the future? I think the odds are at least 70% that we will see a negative print in U.S. GDP growth in the next two quarters. I have given a lot of time to study Consumer Metrics Institute Indexes in recent days. In short Consumer Metrics Institute uses internet purchases of major discretionary items to serve as a leading indicator for consumer spending and ultimately GDP. That makes sense as GDP swings come mostly from changes in discretionary items purchases.
In recent time Consumer Metrics Institute measures (I use 91 day growth rate in CMI Composite Index as a proxy) signal a contraction similar to one in 2008 with difference that current contraction is longer in time. The contraction still has not reversed its course. What to think on this…I seriously doubt that Consumer Metrics Institute has a such flaw in their methodology to make large scale mistake, so there are high odds that consumer spending contribution to GDP growth will be negative from Q3 2010.
Consumer spending slowdown comes in time when government stimulus is wearing off. Consumer and government spending combined represent more that 90% of U.S. GDP.
Chart 1. U.S. GDP q-o-q vs. ECRI Weekly Leading Index y-o-y & Consumer Metrics Institute Composite Index 91-Day Growth
Chart 2. S&P 500 vs. Consumer Metrics Institute Composite Index 91-Day Growth
Judging by other leading indexes my overall impression is that they are pointing to zero growth at best.
Looking at major groups of coincident economic indicators currently there are no meaningful improvements in industrial production, employment, housing, construction spending, durable goods orders…
Thinking on what policymakers response to the slowdown could be…I think that the odds for further serious, large scale, FED asset purchases are at least 95%. From the last weeks FOMC members speeches, Mr. Bernanke has strong support for its money printing policies.
FED’s is not even trying to hide it’s intentions. Brian Sack, the head of the New York Fed’s markets group:
Nevertheless, balance sheet policy can still lower longer-term borrowing costs for many households and businesses, and it adds to household wealth by keeping asset prices higher than they otherwise would be.
Such attempts ended badly in history; but the market view here is: “this time it will be different” …again.
Looking at the other parts of the globe… In Europe, favorable exchange rate effects are wearing off and the slowdown is materializing here also. Japan also slowing down.
China eased it’s monetary policy and real-estate prices grip in recent month or so, so China economy returned to the growth rates from the H1 2010. Other emerging economies are resource based, so they are doing well because of monetary stimulus. There is no decoupling; if developed world slows down the emerging markets will again suffer more than the developed.
Will further asset purchases restore economic growth: it didn’t succeeded in Japan in 80’s I will not succeed in U.S. now.
Equities
I still believe that the market is overvalued; I believe that there is disconnect in what equity and bond markets are pricing – with equity being wrong; I believe we will correct to sub 900 level in the S&P 500.
Bonds
I think that Mr. Bernanke game plan is to have interest rates low longer than anyone expects (I don’t expect a rise in 2011); I believe that the quantitative easing will get some sort of extension comparable in size with the first leg (probably when we see second notable leg down). I expect that the short-term price trends in economy to be deflationary because of private and household sector de-leveraging (leading to weak demand) and large output gap (leading to strong supply).
Because of deflationary expectations I believe that the demand for government debt will be strong especially from bank side as they have large amount of cash reserves they are not using to lend to private sector.
I believe yields will go further down and curve will flatten further; in the longer term I believe the yields will be comparable to Japanese (bellow 1.5% for 10-year government bonds and bellow 2% for 30-year government bonds)
Commodities
Fundamentally, across all mayor commodities supply/demand balances weigh on supply side. Copper would be only here where we have some tightness (again, the talk of copper market tightness arises before market crashes). Excess money in the system has lifted the prices across the board.
Energy Commodities
Crude Oil – fundamentally, the market is over supplied; since crude oil is a high beta play on equity markets my target for WTI spot at 50 in the next six months.
U.S. natural gas – the supply/demand balance is better then last year, but altogether bad. Oversold, In my view one should go long here.
Industrial Commodities
Markets well supplied, if world economy slows down, this is the place to go short.
Agricultural Commodities
It is possible that China starts to boost its inventory of agricultural commodities. This appears to be the commodity class with smallest degree of over-valuation. If you believe in inflation, this is the commodity I would use for hedging.
Precious Metals
Short term, I see gold overbought and over-owned. And this has gotten worse in September.
Long term, in light of further fiat currency confidence problems the precious metals are place to be. I would buy this on meaningful correction.
Currencies
Despite FED being keen to fight every market weakness with dollar weakening my stance is unchanged. If economy is slowing down, U.S. dollar will serve as a safe haven.
I still expect a strong(er) U.S. dollar and weakening of the Euro. I expect yen weakening against U.S. dollar and the Euro. Resource currencies could lose part fall on weaker commodity prices.
Agricultural Commodities, Aluminium, Ben Bernanke, Copper, Crude Oil, Euro, FED, FOMC, Gold, Japanese Yen, Natural Gas, Steel, U.S. Dollar