Fri, 24/08/2012 - 11:05
As bond and equity trading desks whittle down to skeleton crews, new bond issuance slows to a trickle, and policymakers become more difficult to find, global economic issues seem to fade into the hazy days of August, says Scott B MacDonald (pictured), Head of Research/Senior Managing Director, MC Asset Management Holdings…
In the US more attention is being given to the political contest between incumbent President Barack Obama and his Republican challenger Mitt Romney. Considering the campaign’s nastiness and the polarisation of the voting public, this is more fun than seeking to divine communiqués from European Central Bank and Bundesbank officials and that region’s political class. In many regards, the commentary coming out of Europe has become so much white noise, a steady background sound in which it is difficult to distinguish anything intelligent. At the end of the day, what really matters is whether or not the uneven global economic recovery is going to continue. This is what drives corporate earnings forecasts, consumer demand and investors’ appetite for risk. In this we are constructive, but the downside risks are substantial, some of which will play out in September.
While European data continues to be generally negative, US data remains mixed, though with more encouraging signs than discouraging. Along these lines, the housing market is important to the growth story. This past week, sales of existing homes climbed from an eight month low in July. This was followed by July’s rise in new home sales, which according to Capital Economics “does little to dissuade us from the view that the housing market has shifted from being a clear drag on the wider economy to offering some modest support.” The improvement in existing homes comes from cheaper properties and record-low mortgage rates. On the new homes side, the supply of new homes for sale shrank to 142,000, the lowest level on record. Low supply could force homebuilders to build more homes. It is worth noting that Toll Brothers, one of the larger home builders, showed a better-than-estimated profit for its FY Q2 2012.
Trends and Expectations:
Overall, the market reflects a greater willingness to assume risk. This leaves the Dow hanging a little above 13,000, the VIX well below 20 (around 16 today with a little uptick), and IG18 a little over 100 bps. The willingness to assume greater risk is also filtering into the market for Japanese Government Bonds (JGBs).On August 23rd, Japan held an auction of 20-year Japanese bonds. The response was the lowest demand in more than two years. The reason for this is that investors appear less concerned about safe harbor investing (i.e. in Japan) and are looking to other markets with a view of greater risk tolerance and more yield. This is taking them out of Japan and into the US
Along the same lines, there is an expectation of QE3. Although we are not a big fan of QE3, many investors believe that it is coming, most likely in September. The minutes from the early August FOMC meeting strongly hinted that the US central bank will launch a third round of quantitative easing, due to the following language: “many members judged that additional monetary accommodation would likely be warranted fairly soon unless incoming information pointed to a substantial and sustainable strengthening in the pace of the economic recovery.” While we do not see much stronger data, we do see continued economic momentum. Nonetheless, if the Fed does not act in September, it places the next FOMC meeting too close to the November elections for any central bank action to look anything but political. This means that although a third injection of QE into the economy is not likely to have the same positive impact on equity and commodity prices, it may help boast investor and economic sentiment through the fall and past the elections. We would look to the August 27th speech of the Fed’s Charles Evans in Hong Kong for hints of the Fed’s direction. The sad thing is that Fed policy has become a substitute for a Congress unable to do its job.
The combination of QE3, modest growth in the US and Europe’s ability to somehow push the process a little further are giving investors more hope that equity markets will end the year up and ten-year Treasury yields will be around 2.0%. There is also a view that the US fiscal can will somehow be kicked down the road into later 2013, allowing the US to avoid falling off the “fiscal cliff”. All of this, if it occurs, would also be positive for the US corporate bond market, including high yield.
The big spoiler for investors and the global economy remains Europe. We all know that the crunch time is coming in September between the German constitutional decision, Dutch parliamentary elections and troika mission to Athens. Europe’s fate will hit the crossroads – again. Yet, there remains a belief that Europe will bull through. We think that Greece may indeed get a little extra time for implementing its program (despite all of the gloomy Germans saying otherwise) and that the badly needed €31.5 billion IMF/EU bailout tranche will be granted (not without some last minute fear thrown into the market). If so, Europe’s sovereign debt crisis will refocus on Spain, which will ask for a little more aid beyond the banks and receive greater help from the ECB. If all of this comes about, Europe might actually be able to push back the day of reckoning into 2013.
The global economy thus is likely to remain in recovery mode, with global real GDP above 3% for 2013. Nonetheless, risk is like the multi-headed hydra of Greek myth. Cut off one head and another grows back. The positive development of the US to make it through the elections and the fiscal cliff risks, could be entirely negated by other factors – a war in the Middle East, a closing of the Strait of Hormuz or the whiff of conflict between China and Japan over maritime boundaries. There remains a complex matrix of risk factors that refuses to slink away. However, the last two weeks of August are upon us, letting the harder forms of reality sink into the haze – at least until they come back with a vengeance in September.
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