Recovery hopes spoiled by the consumer

News that US Q2 GDP dropped by less than expected, with the 1% fall in GDP over the quarter far smaller than the annualised 6.4% drop in the previous quarter, adds to the plethora of evidence highlighting that the US recession is coming closer to ending.  The bad news, albeit backward looking was revealed in the downward revisions to growth in the previous quarters, which indicated that the recession has been more severe than previously thought.  

Within the Q2 GDP data the details revealed that consumer spending weakened by far more than expected. The recession is also breaking all sorts of records as the annual 3.9% decline in growth was the biggest since WWII and the fourth quarterly decline in a row was the longest on record. Nonetheless, inventories look a lot leaner following their sharp drop over the quarter and the deterioration in business investment appears to be slowing.  The data also showed that the Fed´s preferred gauge of inflation (core PCE deflator) remained relatively well behaved.

The downward revisions to past data and the fact that growth was boosted in Q2 by government spending as well as very weak consumer spending will takes some of the shine off the less than forecast drop in GDP.  Nonetheless, the data is still backward looking.  The evidence of recovery highlighted in recent housing data as well as some bottoming out in manufacturing conditions, taken together with less severe readings in jobs data  are difficult to ignore.  This was echoed in the Fed´s Beige Book which revealed that economic deterioration was becoming less marked.

The most worrying aspect of the report and something that cannot be downplayed however, is consumer spending. Massive wealth loss, rising unemployment, tight credit conditions, reduced income and consumer deleveraging all point to a very subdued outlook for the US consumer in the months ahead and only a gradual pace of economic recovery. The US savings rate is set to move higher even from its current 15 year high and spending on big ticket items will remain fragile at best.   Although the upcoming US jobs report will likely show a less severe pace of Job losses in July, the drop in payrolls will still remain significant and hardly  conducive of a turnaround in spending. 

Although some policy makers have indicated that policy should not be kept too loose for too long the weak consumer outlook suggests that inflation is likely to remain subdued for a long time to come.  So whilst it is easy to get excited about the signs of recovery increasingly being revealed in economic data this should not be taken as a cue to reverse policy. The recovery process remains a “long, hard, slog” and the massive excess capacity in the global economy, especially  in developed countries suggests that interest rates will remain at ultra low levels for many months.

Some clues to central bank thinking will be seen over coming days as interest rate decisions in Australia, UK, and Eurozone move into focus. Although none of the Banks are expected to tighten policy it will be interesting to see whether the rhetoric becomes more hawkish. The RBA in particular will likely indicate that the room for further rate cuts has diminished. In Europe, following the very soft inflation data in July the ECB will be comfortable in its current policy settings.  In the UK attention will focus on the BoE´s asset purchase programme and the possibility of increasing purchases from the current GBP 125 billion, especially after the MPC surprisingly did not increase purchases at its last meeting.

News flow to remain volatile

In past posts I wrote that it will take positive news as opposed to less negative news to drive the rally in equity and credit markets forward.   Although I remain doubtful about the durability of the rally over coming months, there has been good news on the earnings front up until now, and equities have rallied strongly as a result.

Of the S&P 500 companies reporting Q2 earnings 74% have beaten forecasts.  Although there are still many companies scheduled to release earnings, if this pattern continues it would be the highest on record.  Data releases have also given reason for optimism even in Europe where manufacturing gauges and the closely watched German IFO showed some improvement.

Unfortunately, the news was not all unidirectional as Amazon and Microsoft spoiled the party somewhat with their below forecast earnings.  US consumer confidence dropped for the first time in 5 months according to the Michigan survey as rising unemployment in particular weighed on sentiment.  Meanwhile, in the UK GDP data revealed the severe and broad based nature of the recession.

The news flow will continue to remain volatile in the weeks ahead.  The bottoming out process for many economies will be drawn out and rising unemployment and tight credit will act to restrain consumers.  Banks will face spiralling defaults on credit cards and increasing loan delinquencies as some recent earnings have revealed.

Unlike past recessions emerging markets are leading the recovery, especially in Asia as recent data has revealed.  Nonetheless, unless the developed country consumer engine kicks back into life the sustainability of Asian and emerging market recovery remains in doubt.

It is telling that currency markets are not reacting too sharply to the recent positive earnings news.  On balance the usual losers, dollar and yen, in an environment of improved risk appetite, have come under pressure.  In contrast, risk currencies such as the Australian, NZ and Canadian dollars have strengthened. Other high beta currencies are also stronger. Nonetheless, for the most part currencies remain in well worn ranges and as liquidity thins further over summer, there appears to be little scope for new trends in FX markets.

I still favour some dollar resilience over coming weeks as renewed market doubts creep but this view is becoming increasingly difficult to hold.  The reality is that currencies will track equities, which in turn will be dependent on earnings.   If the current earnings trend continues the dollar will face even more pressure but not to the extent that it breaks out of recent ranges.

Risk trades under pressure

Having given presentations in Hong Kong, China and South Korea in the past week and preparing to do the same in Taiwan and Singapore this week it is clear that there is a lot of uncertainty and caution in the air.  

There can be no doubt now that risk aversion has forcibly made its way back into the markets psyche.  Government bonds, the US dollar and the Japanese yen have gained more ground against the background of higher risk aversion. 

Following a tough week in which global equity markets slumped, oil fell below $60 per barrel and risk currencies including many emerging market currencies weakened, the immediate outlook does not look particularly promising.

Data releases are not giving much for markets to be inspired about despite upgrades to economic growth forecasts by the IMF even if their outlook remains cautious.  US trade data revealed a bigger than expected narrowing in the deficit in May whilst US consumer confidence fell more than expected in July as rising unemployment took its toll on sentiment.   There was also some disappointment towards the end of the week as the Bank of England did not announce an increase in its asset purchase facility despite much speculation that it would do so.

Rising risk aversion is manifesting itself in the usual manner in currency markets.  The Japanese yen is grinding higher and having failed to weaken when risk appetite was improving it is exhibiting an asymmetric reaction to risk by strengthening when risk appetite is declining.  Its positive reaction to higher risk aversion should come as no surprise as it has been the most sensitive and positively correlated currency with risk aversion since the crisis began. 

Nonetheless, the Japanese authorities will likely step up their rhetoric attempting to direct the yen lower before it inflicts too much damage on recovery prospects.   The urgency to do so was made clear from another drop in domestic machinery orders last week as well as the poor performance of Japanese equities.  

The US dollar is also benefitting from higher risk aversion and is likely to continue to grind higher in the current environment.  Risk currencies such as the Canadian, Australian and New Zealand dollars, will be most vulnerable to a further sell off but will probably lose most ground against the yen over the coming days.   These currencies are facing a double whammy of pressure from both higher risk aversion and a sharp drop in commodity prices.    Sterling and the euro look less vulnerable but will remain under pressure too.   

There are some data releases that could provide direction this week in the US such as retail sales, housing starts, Empire and Philly Fed manufacturing surveys.  In addition there is an interest rate decision in Japan, and inflation data in various countries. The main direction for currencies will come from equity markets and Q2 earnings reports, however.  

So far the rise in risk aversion has not prompted big breaks out of recent ranges in FX markets.  However, unless earnings reports and perhaps more importantly guidance for the months ahead are very upbeat, there is likely to be more downside for risk currencies against the dollar but in particular against yen crosses where most of the FX action is set to take place.

Watch out for the pitfalls in H2 2009

Equity and credit markets have begun the second half of 2009 looking quite fatigued, which is not a good sign ahead of the Q2 earning season.   Perhaps the fact that markets have come so far in such a short period of time has itself prompted a pause. An alternative explanation is that the summer lull is kicking in, with many investors taking the end of H1 2009 as an excuse to book profits and wait until activity picks up again post summer holidays.  A more worrying and more likely explanation is that the massive improvement in market sentiment seen in H1 2009 is  giving way to uncertainty.

Relief that there will be no collapse of the global financial system is not sufficient to keep the momentum in equity and credit markets going into the second half of the year. Until now there has been plenty of less negative news and use of the now worn phrase “green shoots”, but little information to judge the magnitude and speed of recovery going forward.

There are plenty of factors that will dampen recovery in the months ahead. Higher unemployment, massive wealth loss and increased savings will provide a clear downdraft to the global economy. Banks will be increasingly laden with bad loans due to credit card delinquencies, commercial real estate defaults and other sour loans and are unlikely to step up lending in a hurry. In addition, it is still unclear how quickly toxic debt will be removed from banks’ balance sheets, which will act as another impediment to recovery.

Risks outside the US remain significant. Although the outlook for China is improving it is unclear whether the momentum of growth in the country will continue once current stimulus measures are utilised. Much will also depend on whether China and other export economies can shift growth impetus from external demand to domestic demand.

Moreover, concerns about the dollar’s use as a reserve currency continue to intensify as various large reserve holders attempt to diversify away from the dollar.  Although a dollar collapse is unlikely the risk that foreign investors reduce their exposure to US Treasuries remains a threat to the dollar.   This could push up long term interest rates and in turn mortgage rates in the US.  

The European economy is a particular riskto global recovery, with only a gradual recovery expected.  In particular, the biggest Eurozone economy Germany is struggling in the wake of a collapse in exports and a lack of domestic demand. Moreover, banking sector issues remain unresolved especially as there has been little information on European bank stress tests. The relative strength of the euro and inability of some countries in the Eurozone to devalue their way out of the downturn will also dampen recovery prospects.   These factors suggest that Europe will lag the recovery in other countries such as the US and UK where the policy response has arguably been more aggressive.  

The jobs market will lag the recovery process but there are signs that things are becoming less severe.  The pace of job losses in many countries is lessening.   In the US for example, non farm payrolls report revealed that average monthly job losses in the second quarter of 2009 at 436k were much lower than the 691k average monthly job losses in the first quarter.  The bad news however, is that unemployment rates continue to rise.  In the US the unemployment rate is likely to head to around 10% from 9.5% currently and this will be echoed in Europe where the unemployment is at a 10-year high of 9.5% currently. 

The bottom line is that the market rally may have been justified so far but there is little to carry the momentum forward. Equity valuations dropped to low levels in March but can be hardly considered cheap at present. The improvements in indicators of market stress have also reached dramatic levels and going forward there will be plenty of pitfalls in the months ahead.

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