The rise in interest rates, copper prices, and crude oil suggests stronger economic growth than the anticipated 2.5% by the end of next year, a rise in the dollar and pressure on bond yields, says Jeffrey Saut at Raymond James. The payroll tax reduction of 2% to 4.2 should add some $1,000 of disposable income for the average $40,000 - $50,000 per year wage earner. Barclays argues that non-U.S. investors are not shunning U.S. bonds, and last month’s sell-off was simply the market’s reaction to better-than-expected economic data.
Mark Luschini, Janney, Montgomery Scott.
An underwhelming employment report did nothing to dissuade equity investors from remaining upbeat about stocks. Recent economic data have been consistently positive, including a separate report on jobs from ADP on Wednesday that seemed to telegraph what was widely expected to be a strong payrolls figure on Friday. Instead, the Bureau of Labor Statistics showed just 39,000 jobs were created in November, much fewer than the 140,000 expected and a sharp decline from October’s 172,000. Market participants seem to have assumed a positive bias toward their interpretation of data, aka the glass half full, allowing equity prices to drift upward on the week’s last trading session. Overall, the Dow Jones Industrial Average gained 291 points for the week, or 2.7%, to finish at 11,382. The S&P 500 index rose 3%, and rests just 1 point from its 2010 peak, erasing effectively all of the declines from the late April to July swoon. Meanwhile, the yield on 10‐year Treasuries cracked 3%, the highest since July. The benchmark’s yield is up about 0.5% from the time the Fed’s Treasury bond buying binge was informally announced by Chairman Ben Bernanke at the foot of the Grand Tetons.
The recent concern over Ireland’s financial stability is a reminder that the risk of more aftershocks emanating from Europe stemming from the financial crisis lingers. This holds for the other peripheral countries, such as Portugal, Italy and Spain, as participants under the Euro as a single currency. The merits of a currency‐per country approach can be found by comparing Iceland and Ireland. Both economies were burdened with debt, and their banking systems were overly levered. Of course, Iceland’s banking system was crushed, and their stock market dropped by more than 95% from 2007 highs. However, Iceland adjusted by devaluing its currency and implementing draconian austerity programs. By way of comparison, Ireland could not devalue its currency since it is a member of the European Union (EU), so its economy was caught in a debt deflation spiral. As a consequence, the government had to accept the €85 billion bailout package from the EU and the IMF, and along with it, stiff austerity measures. The problem facing Ireland is that fiscal austerity in the absence of a currency devaluation to inflate growth serves to dampen demand. The threat grows if the contagion leaks to Italy or Spain, the third and fourth largest countries in the EU. Then, solving their fiscal needs and the prospect for the aggregate growth across Europe as well as the existence of the Euro currency is in question. For investors, maintaining international exposure is prudent, but opportunities in overseas markets are much more appealing in the developing countries of Asia, Africa and Latin America.
Jeffrey Saut, Raymond James Equity Research
Copper is often referred to as “Dr. Copper” for it has a better predictive record on economic growth than many economists; and last week copper came a cropper as it traded to new all-time price highs. Another interesting chart is crude oil, which shows a monthly price rise of more than 11%. Clearly, these charts are suggesting the pending U.S. tax compromise, combined with QE2, will foster larger than expected positive surprises for U.S. economic growth. Contrary to consensus opinion, it also implies further U.S. dollar strength and more upward pressure on bond yields.
To me, the biggest surprise of the tax compromise is the payroll tax reduction of 2% (to 4.2%). This alone should add some $1,000 of disposable income for the average $40,000 - $50,000 per year wage earner. Further, the extension of the Bush tax cuts is tantamount to passing a second fiscal stimulus package, “footing” to about 40% of the 2009 initiative. The resulting impact on our economy should accelerate GDP to better than the anticipated 2.0% - 2.5% rate by the end of 2011. The quid pro quo is that the 10-year Treasury’s yield will likely approach 4%. Nevertheless, that does not mean stocks can’t continue to rally.
Plainly, the rise in interest rates, copper prices, and crude oil is suggestive of stronger economic strength than is currently envisioned. That view is reinforced by the purchasing managers’ report that anticipates factory sales will grow at 5.6% in 2011 with a concurrent ramp in capital investment of 15%. As often argued in these missives, the 2009 – 2010 corporate profits explosion has led to an inventory rebuild that is being followed by a capital investment cycle. Once companies start spending money on capital equipment (capex), hiring will increase with an ensuing “hop” in consumer consumption. That is the way the business cycle has historically worked, and I see no reason it will not play again. Indeed, despite the headlines, if you talk to temporary help agencies you find hiring, except for construction, is booming. This is being reflected in the JOLTS report, which shows job openings increased by 12% in October. Consumer sentiment is also improving, as are retail sales, punctuated by October’s $3.3 billion expansion in consumer credit. So I’ll say it again, “To the underinvested portfolio manager (PM) the current economic and stock market environments are a nightmare!” Not only do such PMs have performance risk, but bonus risk and ultimately job risk. Accordingly, my sense is the S&P 500 (SPX/1240.40) will probably rise to above 1250 this week and then consolidate before embarking on another leg higher.
If this scenario plays, and stronger economic growth materializes, the various markets should start discounting a normalization of Fed policy. All we need is a few good employment reports and the dollar, as well as interest rates, should rise. Interestingly, if interest rate differentials widen between the rest of the world and the much maligned Japan, Japan’s currency should fall, fostering a surge in Japan’s exports. I have been wrong-footedly bullish on Japan since the summer of 2009. And while I have not made much money there, I haven’t lost much money either.
Barclays Capital, Market Strategy Americas
Rates should stay range-bound for a few months before resuming their rise next year. We expect a continued economic recovery and the tax cut extensions to pressure yields higher, but that should be offset by strong Fed buying and the recent trend in US inflation data. The debate over the future of housing finance and the GSEs will pick up in Q1, but we do not expect any transformative changes.
Political uncertainty and heavy early 2011 issuance will likely keep euro area sovereign spreads volatile for the time being. While there has been significant contagion between countries, the broader effect on the rates (and other assets) market has been limited. We expect this relatively limited impact to continue. The ECB’s stance and international developments are likely to remain the key drivers of rates; after the sell-off, though, we would expect some stabilisation in Q1 2011.
For Japan and Australia, we expect the better economic data to fuel a further increase in rates, despite the recent sell-off. In Japan, while short- and medium-term rates will likely remain broadly stable, risks are biased towards steepening from the 7-10y sector onwards, particularly for post-10y rates, where long positions are already large. In Australia, we expect the short end to lead the moves, with the RBA likely to tighten further in late Q1 or early Q2 2011.
US: First a breather, and then a sell-off
QE2 has been the main driver of US rates for much of Q4 2010. Rates started rallying in mid-September as investors speculated that the Fed would initiate a second round of quantitative easing. The next several weeks were dominated by questions about the Fed’s intentions, how big the program would be, what assets would be targeted, and which parts of the curve would be affected. The 10s/30s curve was a good example – flattening before the announcement on hopes of greater sponsorship by the Fed, only to steepen immediately after the November FOMC meeting as those hopes were dashed.
In the past few weeks, though, a new dynamic has crept into rates markets. Rates sold off 40-45bp in the belly of the curve (5s and 10s) in November. As a result, nominal yields are now higher than they were in mid-September, when QE2 first started to be priced in. Several theories have been floated to explain this move. One is that Fed buying has been nullified simply by a rise in inflation expectations, pushing nominal yields higher. But this theory is belied by the fact that much of the November move higher in nominals is due to real rates; breakevens rose mainly in September and October. We have also been asked whether non-US investors have started to shun USD assets, since the Fed is creating so many new dollars and given the displeasure expressed by several foreign governments about QE2. But the USD actually strengthened significantly against most major currencies in November, which would be unlikely if there were a buyers’ strike against USD assets, including US Treasuries. Rather, we think the rate sell-off in November is simply the market’s reaction to better-than-expected data. After all, it was not that long ago that many investors seemed convinced that the US was headed towards a double-dip recession. Since then, despite the disappointing unemployment rate, most economic indicators have strengthened – jobless claims have headed lower; personal consumption has been revised higher; personal income, as along with wages and salaries, is climbing; and GDP growth has been better than consensus.
Barclays Capital, Commodities Weekly
The recent rally in oil prices has brought back some optimism in the oil market with a renewed focus on the scale of the potential gains in 2011. The accumulation of upside demand surprises, robust economic indications and a fast rebalancing of the inventory position has provided enough fundamental strength to bite into the widespread demand pessimism that had prevailed throughout the year, thus allowing a better realignment between price and fundamental dynamics. Further sustained price progression however is likely to encounter increasing resistance from here. The fast appreciation of the past two months reflects prices catching up with a prolonged phase of improving fundamental dynamics that, however, had failed to translate in any price upside, largely due to downbeat macroeconomic sentiment. That continued build up in fundamental pressure has finally broken through the wall of macroeconomic concerns, causing prices to adjust swiftly. Indeed, the scale of physical market tightening throughout the year, and particularly Q3 10, has been remarkable as illustrated in the chart below. Between Q3 08 and Q2 09 – the lowest demand point for any quarter throughout the cycle – global oil demand fell by a cumulative 2.4mb/d while OPEC production contracted by 3.3mb/d, with that cut already helping place the market back onto a gentle tightening path. Yet, that tightening process has gathered significant momentum through 2010. Between Q2 09 and Q3 10, the upswing in global oil demand has been a staggering 4.6mb/d but the increase in OPEC production has been a mere 0.8mb/d. In Q3 10 alone, the q/q increase in global oil demand was 2.1 mb/d but OPEC output was just 0.19mb/d higher. That opening gap is behind the recent price increases, which raises the question on how dynamics will evolve. In our view, the scale of upside demand surprise seen in Q3 is unlikely to be repeated in Q4 while OPEC output might start to quietly creep higher should recent price gains consolidate. In other words, while the oil market balance remains on a constructive path, it might lose some of the extreme shine that has characterized its evolution over the past quarter, thus slowing the upwards progression in prices.
Maybe Cancun Can
Week 1 of the Cancun climate conference (COP16) is finished and we are pleasantly surprised as much of the acrimony that plagued Copenhagen has largely been absent. The COP did get off to a rocky start, with Japan on day 2 giving its clearest opposition to the Kyoto Protocol, although this really was not news. Things started to improve when one of the big questions – the legal basis of the new agreement – was tackled in the opening plenary. An agreement was reached that effectively pushed the issue into next year so that the focus of this COP can be on things where some progress can be made. Last year, the legal basis issue caused talks to collapse for a day so having it wrapped up and out of the way in one session was an achievement, although it does keep trying to rear its head and keeping a lid on this will determine how much Cancun actually delivers. A nice surprise came from India, which proposed measuring, reporting and verifying (MRV) emissions and emission reductions that everyone, even China, seemed to like. MRV has been an issue that the US and Europe have been pushing the developing countries on and getting early resolution on this would be remarkable, although the exact content of the proposal remains opaque. The importance of MRV is that if you can measure it, then you can begin to more effectively regulate it and thus MRV is a key to opening up a number of doors, particularly relating to developing country mitigation actions and finance for adaptation. The other area that saw progress was on reducing emissions from deforestation (REDD+), which was another area where expectations for some agreed text were high. If we do get an agreed text it will set out the principles on how REDD+ is to be treated. What it will not do is set out the detail on issues such as MRV of REDD+, the forest baselines, how to deal with reversals or how to use market mechanisms. The last area to note this week is that there will be some more reform for the CDM coming out of COP, with items such as an appeals process against decisions on projects being introduced looking likely. While none of this has much potential to move the market in the short term, it is good news for climate policy.
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