Anxiety over Swine flu

Although I have been writing about various factors that could derail the rally in equity markets and improvement in risk appetite over recent weeks I did not envisage that a virus such as Swine flu would be one of the factors to consider. However, it is and the stress and anxiety about its effects on the economy and of course health are rising rapidly.

In Hong Kong where I have been based for the last 8 months the concerns are particularly acute. Exposed from a high proportion of tourism as a percent of GDP, high population density and its importance as an air travel hub, Hong Kong is somewhat more sensitive than many other countries. Moreover, the memories of SARS and its devastating impact on the economy still linger for many people. A local paper revealed such tensions in its headline, “its creeping closer”

Nonetheless, there is little in terms of concrete evidence to go on and outside of Mexico the health impact of the virus has not been as severe. Even in Mexico there have been conflicting reports about the actual amount of deaths, with some putting it at a much smaller number. Until there is some clarity markets will continue to react to the uncertainty. The rapid spread of the flu has sparked fears of a global pandemic but it has yet to be categorized as such.

Risk indicators have not yet reacted sharply even if equity markets have been hit over recent days, suggesting that at the least there is not a panic in markets. Even the usual FX beneficiaries of higher risk aversion such as the US dollar and Japanese yen have not strengthened and remain in a broad range. It is difficult to predict the damage from the flu and much depends on its severity and how much it spreads but the relative calm in the market is at least encouraging for now.

A taxing time in the UK

It has been a truly gloomy week for the UK economy.    Firstly there was the shock budget announced by UK Chancellor Darling in which the scale of UK borrowing requirements became worryingly clear.  To summarise briefly the government expects tax revenue to come in at around £175 billion or a whopping 12.4% below public spending in this fiscal year.   What’s more the bulk of this is structural or persistent so will not be erased without adding another layer of taxes. 

It will take several years to reduce the budget gap according to the budget estimates, with the government predicting that the deficit as a percent of national income will drop to 1.2% by 2017-18 but this relies on highly ambitious forecasts.  The scale of government borrowing required and the reliance on government bonds to bridge the gap is worrying enough and has caught the attention of ratings agencies.   It also effectively rules out further stimulus should the economy turn even more sour than expected or if anticipated recovery does not take effect.    

The bigger problem is that the deficit reduction plans bank on highly optimistic and probably downright unrealistic growth growth forecasts.    This was demonstrated by data released shortly after the budget announcement revealing that the economy shrank by a much bigger than expected 1.9% in the first quarter of this year,  the worst growth outurn since the third quarter of 1979.    So much for hopes that the worst was over at the end of last year.   Although the government has said that this does not alter their budget forecasts, as they are based on growth for future months, it does reveal that they vastly underestimated the depth of the recession in the UK.  

Even the forecasts for economic growth in the next few years look highly ambitious with the pace of contraction forecast to ease over coming quarters and stabilise by year end.   Further out, if growth does not pick up as forecast there is a real risk that not only will tax rates not be reduced for several years but that the UK taxpayer is destined for even higher taxes for years to come.     

There has much press on the increase in the high rate of income tax from 40% to 50% but the reality is that this will only bring in a small amount of revenue and will do little to close the gap between spending and tax revenues.   It will require a substantial easing in spending for the government’s plans to have any validity.  It appears that the aftermath of the bursting of the debt fueled consumer spending bubble is still being felt and will continue to do so for years to come, much to the expense of the taxpayer.

No “green shoots” in the jobs market

 

Over recent weeks various officials have highlighted signs of stabilisation in economic conditions.  Indeed, economic data have been coming in less bad than feared. Nonetheless, one indicator is likely to take a considerably longer time than others to turnaround.  The jobs market is set to continue to deteriorate globally for many months after other economic indicators stabilise.  In the US the pace of lay offs has been dramatic, with 5.1 million jobs lost since December 2007 and 2/3 of these registered in the last five months alone.
 

The US unemployment rate currently at 8.5% is set to move to potentially as high as 10%, with the change in the rate from its cycle low already greater than any time since WW2.  The contraction in the economy points to much further job losses in the months ahead.  The good news is that a smaller pace of economic contraction ought to result in smaller declines in payrolls over the coming quarters and this implies a decline from the Q1 monthly average of 685,000 job losses.  Nonetheless, this doesn’t mean there will be a quick improvement either. 

 

There are several other implications of rising unemployment.  If the unemployment rate does reach 10% it would match the worst case scenario visualized in the Fed’s stress tests for US banks.  Rising unemployment would imply not only less consumer spending, but more loan defaults, more writedowns and more pressure on bank balance sheets.  Just look at the massive provisions that some US banks have built into their forecasts for the months ahead.  The likely slower pace of economic recovery compared to past recessions suggests that any improvement in the labour market will also be more gradual. 

 

Another dimension to the deterioration in the jobs market underway at present is the growing number of temporary and/or contract workers that are being layed off.  A broad US government definition estimates that such workers account for around 31% of the labour market.   If the losses in these jobs are accounted for the unemployment rate could be as high as 15.6% according to the US Bureau of Labour Statistics.   This suggests that the economic impact of rising job losses may be much more severe than predicted.

 

And finally the effect of rising unemployment on wage pressures should not be ignored.   Many employers are not only shedding staff but also cutting wages.  Moreover, a looser labour market in general plays negatively for wages as the demand for labour decreases.   Easing wage pressures is good for dampening inflation pressures but in the current environment it could fuel further fears about deflation, which in turn could be extremely negative for the economy. In the worst case scenario it could even end up as a 1990s Japanese scenario of a downward deflationary spiral which ultimately crippled the economy for a whole decade.   Let’s hope not.

Nervousness sets in

Over recent days a number of banks including Citigroup, JP Morgan Chase, Goldman Sachs, and Wells Fargo and most recently BoA have revealed a return to profitability in Q1.   In Citigroup’s case it has been reported that earnings were helped by an accounting change that allowed it to post a one off gain of $2.5 billion.   However, it’s stock price was unlikely to have been helped by the announcement of a delay to the planned sale of a stake of 36% to the US authorities until the results of the bank stress tests are known. 

There is no doubt that US banks are being helped by strengthening mortgage demand due to low interest rates, improved liquidity in markets and the huge amounts of money that the government is pumping into banks.   High volatility has also helped boost trading revenues.   Nonetheless, uncertainty about the outlook in the months ahead continues to grow due to the risks from corporate loan defaults, a slide in the commercial real estate market and rising consumer loan delinquencies. 

This suggests it will be difficult for markets to get too bullish even if banks continue to report decent Q1 earnings.   Perhaps demonstrating this, even Citigroup’s better than expected earnings failed to prevent its shares falling on the day of its earnings announcement.   This was followed by a fall in BoA’s shares today in pre-market trading despite revealing that profits tripled in Q1.

Indeed, there are appears to be a degree of nervousness creeping back into markets, indicating that the improvement in risk appetite over recent weeks could be stalling as uncertainty about what lies ahead intensifies.  BoA’s increase in provisions for credit losses in Q1 highlights where this nervousness is coming from.   The results of US bank stress tests is the next hurdle for markets and if anything this could lead to more market tensions, especially if some of the banks are found to be requiring additional capital which looks increasingly likely to be the case.

10 questions to ask…

…before you return to the stockmarket.

Equity markets have undergone their biggest 5-week rally since the great depression but there are several questions that should be considered to determine whether the gains will last.

1) Why is the rally in equities broad based? On the face of it a broad based rally should come as good news but it also appears indiscriminate with investors rushing to buy any stocks regardless of the underlying factors. This suggests investors are jumping in without looking where they will land.

2) Why are financial stocks rebounding so strongly? Surely all the problems have not been resolved so quickly. Even if the removal of toxic assets are starting to gain traction markets are unlikely to have anticipated the likely problems coming from a new wave of credit card defaults, and comsumer and corporate loan delinquencies as economic conditions deteriorate and unemployment rises.

3) Have markets factored in the outcome of the results of the stress tests on US banks? These results will be known in about three weeks. Although no bank can fail the tests from a technical perspective, there is every chance that some will be found to be in bad shape and in need of more capital.

4) What effect will the impact of accounting changes have? The relaxation of industry accounting standards in the US mean that it will be difficult to gauge losses on a variety of debt. This could add to the uncertainty surrounding valuations rather than help to end it.

5) How will tensions between banks and the administration impact stocks? There appears to be growing tensions between the US administration and banks over repayment of bailout money and the speed at which banks are removing toxic assets from balance sheets. Many banks in the US are reluctant to announce further writedowns despite pressure to do so.

6) How long will positive data surprises continue? Clearly expectations for economic data had become overly bearish over recent months. Data releases have actually come in better than forecast recently as reality has not been as bad as expectations. This in turn, has helped give more fuel to the market rally. Once expectations become more realistic markets will find little support from positive data surprises.

7) Are markets full pricing in the depth and breadth of the recession? It appears that markets are looking at the current economic downturn as if it was the same as past cyclical downturns. This is unlikely to prove correct as economic conditions will not improve anywhere near as quickly as experienced in recent recessions. Moreover, the jobs market is likely to continue to worsen for many months to come. At best, economic recovery is unlikely until early 2010 and even this may be optimistic whilst any recovery is likely to be slow and mild relative to past recoveries.

8)How compelling are valuations? Although the price side of the P/E ratio has dropped sharply the earnings outlook continues to be negative. Analysts have forecast Q1 earnings to drop by around 37% but as the economy worsens and unemployment rises the earnings outlook could like quite bad for some time to come.

9) Are stocks rallying too quickly? Historically equity markets do not rally so rapidly following such a shock on the downside. Any rally is usually slower.

10) Are stocks rallying too early? Stocks rally around 5-6 months ahead of an upturn in economic conditions but as noted above any recovery in the economy is unlikely before early next year, which suggests the stock rally is premature.

Q1 earnings in focus

Equity markets have continued their ascent albeit with continuing volatility around the Q1 earnings season. Other indicators of market stress have also improved whilst bond yields haved edged higher. Next week will test the markets optimism with a plethora of banks set to release their results for the past quarter. Wells Fargo provided a boost to financials today with its earnings report. Banks will benefit from the changes to mark to market accounting regulations allowing banks more flexibility in valuing their dodgy assets. Although I am somewhat concerned about the political push for the change in these accounting rules it will no doubt ease some of the pressure on banks and their estimates of writedowns.

Meanwhile the economic news continues to be less negative as the bigger than expected narrowing in the US trade deficit reveals. This adds to the run of better than expected numbers over recent weeks that is perhaps showing that the pace of economic deterioration globally is easing. The economic news has also contributed to the better tone to equities and improvement in risk appetite.

Action to prevent the economic and financial crisis from deepening is also creating a floor under markets. The Bank of England left interest rates unchanged but maintained its commitment to conduct asset purchases having done around 1/3 of the planned GBP 75 billion so far, with the remainder to be undertaken over the next couple of months. Elsewhere Japan will provide further fiscal stimulus to boost its flagging economy although the unstable political situation could yet derail such plans. Nonetheless, the picture is clear as policy makers continue their battle to boost sentiment and thaw credit markets.

If markets can get through Q1 earnings without a major set back there maybe hope that the rally really has got legs. I still think there is a whiff of a bear market rally going on but I would happy to be proved wrong.

What drives currencies?

Currency forecasting is never an easy thing to do. The drivers of currencies appear to change over time making it quite tough to develop forecasting tools with great accuracy. This is not an excuse from someone who has been trying to analyse currencies for a number of years but just a statement of reality. Over the past year or so one of the biggest drivers of currencies has been risk appetite. As equity markets sank in 2008 the main winners were the dollar and yen both of which appreciated due to strong repatriation flows and safe haven demand. This influence of risk in determining currency movements saw historical influences such as interest rate differentials pushed into the background.

Where does it leave FX now? Well, if the rally in equity markets continues it implies that both the dollar and yen will fall further whilst long suffering currencies such as the pound will strengthen further. In the pound’s case it has a lot of room to recover given that is massively undervalued by many measures. For instance during my time in Hong Kong the pound against the dollar has dropped by around 30% making things look far more expensive than when I first came. However, to a foreigner UK assets now look quite well priced and London is no longer such an expensive city. Add in the steep drop in house prices and the UK looks even more competitive. This will no doubt benefit the economy in time.

So if the current risk/FX relationship holds it means that we should all be watching equity markets to see where currencies are going to move over coming months. If equity markets fail to sustain their rally it could put the dollar back on the front foot which will see the pound back under pressure. Eventually the dollar will weaken as risk appetite improves and when that happens the pound may be one of the main beneficiaries.

Ps. I hope this works as I am posting this article on holiday. It also means that my contributions may be a bit more sporadic over the next couple of weeks.

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