Amundi Asset Management
The euro sovereign debt crisis should not become systemic: the markets will focus on this theme for many months to come. Greece is unlikely to avoid debt restructuring after mid-2013, while Spanish banks are generating fears of a major risk for Spain and, due to a ricochet effect, for the euro zone as a whole. Major differences between countries having solvency problems, and countries with potential funding difficulties. EUR to remain fragile vs USD.
The global economy is flooded with excess liquidity, which should end up sparking fears of inflation. The risks of a double dip recession are receding, but growth is too weak for the output gap.
The economic discrepancies in the euro zone can be expected to continue in 2011, with Germany and the “core” countries (competitive countries with current account surpluses, fiscal discipline and controlled public debt…) on the one hand, and peripheral countries (current account deficits, poor competitiveness, struggling banking systems, uncontrolled public debt, imposed fiscal discipline).
Monetary policies will remain accommodating in 2011, but the markets will have to prepare for the end of quantitative easing, which is likely to generate inflation expectations even without any pressure from the real economy. Emerging markets like China will continue tightening their monetary policies in order to curb inflation.
H2 promises to be challenging for the bond markets: the end of quantitative easing is becoming a major economic issue. A bond crash is unlikely in a phase of global excess liquidity, which will continue to dominate 2011, but the threat is still very real over the longer term.
2011: a test year for emerging debt - Two risks are coming to the forefront. One is a short-term risk - inflation in emerging countries - while the other is a medium-term risk, namely rising long rates in developed countries and the struggle to maintain the "splendid isolation" of emerging debt. Emerging currencies to remain attractive, particularly in countries with stronger growth, current account surplus, fiscal discipline and inflation pressures still under control.
The bullish cycle on the equity markets is not over yet: our top picks are growth stocks, M&A stories and companies capable of raising their prices. Sector wise, we favour luxury goods, capital goods, pharmaceuticals, mining and energy.
Business sectors will set themselves apart by their ability to pass on commodities price rises: increases in commodities prices are hard to pass on down the line, and the different sectors' exposure to commodities coupled with their pricing power will be crucial to margin developments in 2011. The sectors facing the greatest risk are iron and steel, food, utilities and capital goods.
The credit market is still attractive, but strongly influenced by developments in the sovereign debt crisis: companies are gradually returning to profits and growth, providing support to the credit and equity markets alike. High Yield remains attractive, however the re-emergence of a systemic sovereign crisis would have negative impacts.
Mark Luschini, Janney, Montgomery, Scott: Improving Confidence Augurs Well for the Economy.
Pitchers and catchers have started the annual pilgrimage to sunny and warm parts of the country that begins what Major League Baseball calls “Spring Training.” Maybe the notion that the boys of summer are reporting to their respective teams helped to lift consumer spirits. More likely, it has been improving trends in the job market, stock prices, wage growth and other headlines that boosted confidence, but in either case, higher readings bode well for the economy. So do the trends of corporate profitability. Earnings season is nearing its end and, by most accounts, the reports from companies have been positive. Importantly, earnings are no longer being manufactured by cost cutting. Instead, sales are growing, which is helping to offset rising input costs but should also lead to an increase in hiring. While the effects of weather are still riddling some of the economic data coming out, last week’s figures on jobless claims were at levels normally associated with sustained employment growth. Investors welcomed the week’s reports, along with the resignation of Egypt’s President Mubarak, by tacking 181 points, or 1.6%, on to the Dow Jones Industrial Average. The gain represented the tenth week out of the last eleven that stock prices have advanced.
February’s reading of consumer sentiment from the University of Michigan continued to push higher, nearing its best level since June of last year. As can be seen in the accompanying chart, changes in consumer sentiment have an influence on spending patterns. In fact, for the last ten years, there has been a 60% correlation between sentiment and real consumer spending. Therefore, we expect economic conditions in the coming months to be buoyed further by the more optimistic consumer. However, we will be watching closely the impact of inflation on those still fragile attitudes. Within the University of Michigan survey, respondents stated an expectation of rising inflation over the next year. Higher prices at the pump and in the grocery stores act as a consumption tax, and if they escalate, this could be detrimental to spending and economic activity.
Dean Maki, Barclays Capital, Market Strategy Americas: More Evidence that U.S. Inflation Has Turned
We have raised our CPI forecast in response to firm incoming data on consumer, producer, and imported goods inflation.
Some of the inflation increase has occurred in areas we had expected, i.e. food, rents, and owners’ equivalent rent, but there is also evidence of rising core commodity inflation.
We expect the Fed to welcome rising prices, since inflation will be moving toward the level the FOMC desires.
Two months ago, we argued that core CPI inflation had hit bottom in Q4 10 and would be rising in 2011, despite concerns among some analysts about further core disinflation. The January inflation data showed more evidence in support of this view. The core CPI rose 0.2% in January and increased 1.0% y/y, up notably from its trough of 0.6% in October 2010.
Further, on a y/y basis, the overall CPI climbed a tenth to 1.6%, and we continue to project that food and energy inflation will persistently run above core inflation in the coming months. We view this as an outcome of a strong global growth environment, and believe increasing food and energy prices should be considered part of the trend in inflation. As a result of the incoming data, as well as firmness in PPI, import, and commodity futures prices, we have raised our CPI forecast and now expect the overall CPI to reach 2.3% this year (Q4/Q4), up from our previous forecast of 1.8%. We now project core CPI inflation of 1.3%, up from our previous forecast of 1.1%.
Food Inflation Moving Higher
Food inflation in the PPI has been moving higher for months, in contrast to modest food inflation in the PI. In January, the CPI for food began to catch up, rising 0.5% m/m and pushing the y/y rate up 0.3pp to 1.8%. Further, virtually all of the influences on food inflation look set to push it higher. The finished goods foods PPI climbed 3.7% y/y in January, while the intermediate food PPI increased 6.8% y/y, and the crude food PPI gained 20.4% y/y. Imported food prices rose 14.8% in January. This evidence, along with surging agriculture futures prices, points to further increases in the food CPI, and we look for this measure to hit 4.0% y/y by the end of this year.
The Core Also Rises
Core inflation rose 0.2% in January – an upward surprise. Some of the firming came in areas we expected such as shelter costs, which was the main source of the disinflation in core. Over the past three months, rents have increased an annualized 2.3%, while owners’ equivalent rent has gained 1.2% (Figure 3); these are both up sharply from the negative readings seen early last year. Because together rents and owners’ equivalent rent constitute nearly 40% of the core, their upward trend is the main reason why we expect core inflation to increase this year.
What was unexpected this month was strength in the core commodity CPI, and a continuation of this trend would pose some upward risks even to our upwardly revised inflation forecasts.
For example, apparel prices surged 1.0% m/m in January, and on a y/y basis, the series was unchanged after falling over the past year. While the series is volatile, we would not dismiss the firming. Apparel import prices have climbed 3.2% y/y, the fastest increase in 18 years, and in the past, higher apparel import prices have been associated with rising apparel prices in the CPI. Further upward pressure on core is coming from airfares, which are being pushed higher by rising energy costs and capacity cuts, and are up 9.8% y/y. Overall, we are comfortable with our view that core inflation will be moving higher this year.
Inflation Rise to be Welcomed by the Fed
We believe the Fed welcomes the firming inflation backdrop. The $600bn asset purchase program was started in part because the Fed viewed inflation as too low, and the increases we expect this year would push the overall PCE price index right in line with the roughly 2.0% goal of most on the FOMC. Further, many FOMC members will likely view inflation pressures as still too low at year-end, because they focus on measures that exclude food and energy, and we project the core PCE price index to increase 1.2% (Q4/Q4) this year.
Thus, rising inflation will be consistent with the Fed’s objectives, and we think it will not induce the Fed to hike rates this year. Instead, we expect the Fed to remain focused on pushing the unemployment rate down, since the January FOMC minutes confirmed that most FOMC members continue to believe the natural rate of unemployment is 5.0-5.5%.
Troy Davig and Nicholas Tenev, Barclays Capital, Market Strategy Americas: U.S. Net exports: Short-term Gain, Long-Term Drag
Net exports swung from being a drag to providing a boost to headline growth in Q4. We see any contributions to growth from net exports as short lived, since current structural forces will likely lead to a widening in the trade balance in the years ahead.
Net exports provided a substantial 3.4pp boost to Q4 10 headline growth, partially reversing the tremendous drag exerted in mid-2010 (Figure 1). We do not, however, view these shortterm movements as indicative of an improving trend in the US trade balance. Larger structural forces are set to keep sustained pressure on the trade deficit to widen further.
Domestic growth in the US is poised to move higher and, historically, this corresponds to rising import demand. Buoyant foreign growth is helping to shape an increasingly strong picture for future export growth but is unlikely to be sufficient to tip the trend in the trade balance. A weakening of the dollar could meaningfully affect the trend, but by itself, would not likely be enough to generate persistent narrowing in the trade deficit. Any sustained reversal in its overall trajectory will need to arise from a combination of factors: further weakening of the dollar, higher national saving – which is unlikely given the current outlook for persistent high budget deficits – and stronger foreign growth.
The Source of Financing for the Trade Deficit
One reason to monitor the trade deficit, beyond its immediate contribution to growth, is that its source of financing has fundamentally shifted over the past several years. When a country consumes more than it produces, the difference must be financed either by selling assets, such as equity in domestic companies, or borrowing. In the 1990s, the growing trade deficit was financed by foreign investment in equity and foreign direct investment. Over the past several years, however, a substantial portion of financing has come via debt issuance. Identifying exactly who lends to the US is difficult, but a substantial portion likely comes from governments and central banks. Thus, when the trade deficit is financed via borrowing, as is currently the case, the US is susceptible to shocks that may originate from a shift in the willingness of foreign entities to lend to the US.
Relative growth rates, exchange rates and the trajectory for net exports In explaining medium-term movements in the trade balance, the pace of U.S. growth relative to the rest of the world is a key factor. Figure 3 shows growth in real U.S. consumption and business fixed investment against growth in real imports. Not surprisingly, a tight relationship exists that indicates a 1pp increase in growth in consumption and investment is associated with a rise in imports of about 2.75pp on a y/y basis.
A 1 pp rise in real world growth is associated with a rise in real US exports of about 2.8pp on a y/y basis. Thus, the response of imports to a rise in domestic growth is about the same, in percentage terms, as the response of exports to a rise in world growth. An important distinction, however, is that the trend in import growth has been stronger than the trend in export growth. As a result, the current level of imports is larger, standing at $2.4trn in Q4 11, than current exports, which were $1.9trn in Q4 11. This current imbalance reflects several factors such as differences in saving rates between the US and its major trading partners, as well as persistent strength in the US dollar against certain currencies, such as the Chinese yuan. An implication of this difference in the levels of imports and exports is that a simultaneous 1pp rise in US growth and world growth will boost imports and exports by about 2.75pp but result in a widening in the trade deficit of about $13.5bn.
Movements in the foreign exchange value of the dollar also play an important role in external adjustments. The trade-weighted real exchange rate for the US dollar and net exports as a share of GDP. Two sustained appreciation cycles are evident, the first in the early 1980s and the second in the mid-1990s. Following both of the major appreciation movements, the trade deficit widened for several years. Ascribing full causality, however, of a stronger dollar to subsequent trade deficits is complicated because asset and foreign currency markets move in anticipation of stronger economic growth and higher returns to risk-based assets. Stronger US growth relative to the rest of the world is tightly correlated with a widening trade deficit. Thus, a strengthening in the dollar prior to a trade deficit partially reflects anticipated stronger growth, which in the US is associated with a trade deficit. To untangle the direction of causality, we use a statistical method that allows us to establish causality and isolate the effects of a weaker dollar and stronger world growth on the trade balance. We find a depreciation of the tradeweighted real exchange rate of 10% over five years raises net exports about a cumulative 0.75% of GDP. The impact of the depreciation is persistent, and has a lasting effect on the trade balance well after the five-year horizon. With net exports currently at -3.3% of GDP then, it would take a dollar depreciation on the order of 45% to close the trade gap, all else equal – an eventuality we view as quite unlikely.
In terms of our medium-term outlook, we weigh growth rates between the US and the rest of the world against projected movements in the dollar. Barclays Capital projects world growth of 4.3% in 2011 and 4.4% in 2012. These rates of growth relative to our forecasts of consumption and business fixed investment growth, weighed against a modest weakening of the dollar, lead us to expect the trade balance to widen to $475bn in 2011 and $538bn in 2012 (Figure 5). The majority of this widening is due to growth differentials, with the weaker dollar providing only a minor offset.
Shifting the Trend in Net Exports
In a purely accounting sense, net exports equal total domestic saving less domestic investment. Thus, countries that save a large portion of their output relative to what they reinvest into their own economies run trade surpluses. For the US, a shift towards increased national saving would provide conditions for an eventual improvement in the trade balance.
However, the recent rise in the saving rate to 5% puts it roughly in line with current fundamentals, so it is unlikely to move dramatically higher in the years ahead. Any scope for a substantial improvement in total US saving would need to come from the public sector. However, we believe the US will run sizable budget deficits for the foreseeable future.
Thus, to alter the general trajectory of the US trade balance will likely require a combination of factors: a weaker US dollar, higher domestic saving, and stronger world growth. Absent lasting shifts in the trends for these variables, the trade balance is likely to continuing widening in the years ahead.
Jeffrey Saut, Raymond James: The Cocktail Theory
I was on the West coast last week seeing institutional accounts and speaking at various seminars. The resounding question served up was, “Is this a rally in a bear market, or a new secular bull market?” The follow up question was, “How can you be sure that the pullback, you have wrongly been expecting, is for buying?” Speaking to the second question first, since 1940 there has never been more than one 10% or greater pullback in a bull move; we had a 17% pullback last year between April’s high into June’s low.
Moreover, the retail investor is nowhere close to fully embracing this rally, which is typically what occurs around intermediate/longterm stock market “tops.” Consider this quip from Peter Lynch’s book “One Up On Wall Street:”
“If the professional economists can’t predict economies and professional forecasters can’t predict markets, then what chance does the amateur investor have? You know the answer already, which brings me to my own ‘cocktail party’ theory of market forecasting, developed over the years of standing in the middle of living rooms, near punch bowls, listing to what the nearest ten people said about stocks.
In the first stage of an upward market – one that has been down awhile and that nobody expects to rise again – people aren’t talking about stocks. In fact, if they lumber up to ask me what I do for a living, and I answer, ‘I manage an equity mutual fund,’ they nod politely and wander away. If they don’t wander away, then they quickly change the subject to the Celtics game, the upcoming elections, or the weather. Soon they are talking to a nearby dentist about plaque.
When ten people would rather talk to a dentist about plaque than to the manager of an equity mutual fund about stocks, it’s likely the market is about to turn up.
In stage two, after I’ve confessed what I do for a living, the new acquaintances linger a bit longer – perhaps long enough to tell me how risky the stock market is – before they move over to talk to the dentist. The cocktail party talk is still more about plaque than about stocks. The market is up 15 percent from stage one, but few are paying attention.
In stage three, with the market up 30 percent from stage one, a crowd of interested parties ignores the dentist and circles around me all evening. A succession of enthusiastic individuals takes me aside to ask what stocks they should buy. Even the dentist is asking me what stocks he should buy. Everybody at the party has put money into one issue or another, and they’re all discussing what’s happened.
In stage four, once again they’re crowded around me – but this time it’s to tell me what stocks I should buy. Even the dentist has three or four tips, and in the next few days I look up his recommendations in the newspaper and they’ve all gone up. When the neighbors tell me what to buy, and then I wish I had taken their advice, it’s a sure sign that the market has reached a top and is due for a tumble.”
Manifestly, we are nowhere near stage 3 or 4; so yeah, I think any pullback is for buying. As for the first question, I have not wavered in the belief that since the first Dow Theory “sell signal” of September 1999 the major averages would do what they have done after every secular bull market peak – they would go sideways in a wide swinging trading range. My often mentioned example has been the trading range between 1966 and 1982 following the previous secular bull market that began on June 13, 1949 and ended on February 9, 1966. That wide swinging trading range market experienced no less than 13 swings of 20% or more (both up and down) during that 16-year range-bound environment. Interestingly, while the DJIA made its nominal price low in December 1974 at 577.60, the D-J Transportation Average refuse to confirm with a like new reaction price low (read: non-confirmation). That left the Dow’s nominal price low at 577.60, a level that would not be breached, or even retested, over the subsequent years. The Dow’s valuation “low” (the cheapest it would get in terms of price to earnings, price to book value, price to dividends, etc.), however, was not reached until the summer of 1982. Still, the senior index NEVER came anywhere close to its nominal price low of December 1974. Accordingly, for almost two years I have argued that the nominal price low for the current range-bound stock market came in March of 2009; I have also stated that I would be shocked if the major averages ever come close to those levels again. As for when the valuation “low” will occur is certainly a fair question, but my sense is it is still a few years away. Yet, that does not mean you can’t make money in the stock market, as has been demonstrated by our Analysts’ Best Picks list, which has outperformed the S&P 500 in nine of the past 10 years of a range-bound market.
Conversations with T. Rowe Price Managers
Alan Levenson on the Economy: Unemployment is expected to fall to 8.6% by the end of 2011, with the monthly pace of job growth potentially hitting 200,000 by year-end. QE2 will likely get more credit than it deserves, as the economic recovery was already well underway. As momentum from 2010 continues into 2011, we could enter a virtuous cycle, where encouraging economic news feeds off itself. Positive surprises for 2011 could include further increases in consumer spending, increased release of pent-up demand from businesses, and a serious dialogue about the budget deficit.
David Giroux and Ray Mills on Global Equity Markets: The difficult handoff between a government-led, stimulus-induced recovery to a self-sustaining recovery is underway. Global disparities are becoming more pronounced, as the developed world (particularly debt troubled European nations) is more reliant on government assistance and the developing world seeks to cool growth and inflation. U.S. companies that can access consumers in emerging economies offer attractive opportunities. Higher-quality stocks may start to outperform as the recovery matures. Valuations of large-caps are okay, but not reasonable. Small-caps are overvalued.
Steve Huber and Mike Conelius on Global Fixed Income Markets: The bond market rally investors have enjoyed is ending and returns will be more subdued. U.S. rates and emerging market bond flows benefited from the euro debt crisis. But we are modestly underweight Treasuries, as the Fed will end its buying program in mid 2011. Deficit concerns may apply additional pressure, and rates will likely rise. High yield bonds may offer attractive returns, but will be dependent on continued economic growth and could be hurt by M&A activity and shareholder return on capital. Emerging markets have gotten their fiscal houses in order, as 70% are now investment grade. Additional upgrades are likely this year. Emerging market corporates are closer to the domestic growth story and offer attractive investment opportunities.
