Catching up with reality

September 18, 2009 — Mitul Kotecha

Markets have had an exhilarating run up over recent weeks.  Since the start of the month the S&P 500 has risen by close to 7%,gaining around 58% from its March low, as the evidence of global economic turnaround has strengthened and the outlook for earnings improved.

Nonetheless, the rally in equities has meant that valuations are starting to look stretched again. For instance the price / earnings ratio on the S&P 500 has risen to its highest level since January 2004, perhaps hinting at the need for a degree of investor caution in the days and weeks ahead.

Other factors aside from the pace of the move also call for some restraint to market optimism such as the potential for escalation in trade tensions between the US and China, the imposition of regulations on banks and the timing of reversal of extreme stimulus measures. 

As the panic has left markets over recent months volatility has eased as reflected in the VIX index which has dropped to around its lowest level since September 2008, just before it spiked massively higher in a matter of weeks in the wake of the Lehman’s blow up. 

This has been almost perfectly echoed in the move in currency volatility, which has dropped to around the levels last seen a year ago for major currencies.  These levels are not quite pre-crisis levels but for the most part pre-date the collapse of Lehman Brothers, reversing almost all the spike in risk aversion that took place from a year ago. 

It is probably not too much of a stretch to state that having expunged the shock of Lehmans and the worst fears about the global economy from measures of risk and volatility the room for further improvements may be somewhat more limited.  This may be countered by the fact that economic data continues to deliver positive surprises relative to consensus, providing fuel for a further rally in risk appetite. 

However, a lot of good news must surely be in the price by now and it is likely that even the most bearish of forecasters has to acknowledge that an upswing in activity is underway. This ought to ensure that consensus forecasts catch up with reality, leaving less room for positive surprises and perversely less support for equity markets. 

The rally in risk appetite and equity markets has taken its toll on the US dollar which has had a gruelling few weeks during which the US dollar index (a basket of currencies versus USD including EUR, JPY, GBP, CAD, SEK and CHF) has hit new lows almost on daily basis.  Any pause in dollar selling driven by a softer tone to equities is likely to provide better opportunities for investors to take short positions in the currency given that little else has changed in terms of USD sentiment.   How far can the dollar drop?  Well for a start the April 2008 low around 71.329 for the USD index beckons and after that its into uncharted territory.

Posted in Asia, China, Currencies, Economics, Economy, equity markets, Financial crisis, US. Tags: , , , , , , , , , , , , , , , . Leave a Comment »

Risk trades under pressure

July 11, 2009 — Mitul Kotecha

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.

Posted in Bond markets, central banks, Commodities, Currencies, Economics, Economy, equity markets, Financial crisis, Monetary Policy, US. Tags: , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , . Leave a Comment »

How compelling are equity valuations?

May 12, 2009 — Mitul Kotecha

Relief over the results of the US bank stress tests, better than expected US jobs data, generally less negative economic data in general, as well as better than expected Q1 earnings provided markets with plenty of fuel over recent days and weeks. This has helped to spur an improvement in risk appetite and a resultant strengthening in equity markets. Meanwhile, government bonds have sold off, commodity prices have risen and the USD has weakened.

At the time of writing the S&P 500 has recouped all its losses for the year, having climbed around 34% from its low on 9th March. To many this has sent a bullish signal about the path of the economy ahead given the historical lag of around 5 to 6-months between equity gains and economic recovery but to others include myself this is sending a false signal. Even if the economy stabilizes any recovery is likely to be slow.

As stocks have risen, cautiousness about the current rally has intensified, with many now calling for equities to correct lower. This could partly reflect sour grapes from those investors who have missed the move in equities (I like to think that I am not in this camp even if I did miss the move) but there is also an element of truth in terms of equity market valuations, which have risen sharply over recent weeks. Although arguing whether stocks are cheap or expensive depends on what measures are used there is even some caution coming from equity bulls.

Bloomberg estimates one measure of equity valuation, the Price / Earnings ratio of the S&P 500 at 14.78, which is still below the estimated P/E ratio of 15.96 but much higher than the P/E ratio of around 10 at the beginning of March. Other estimates also suggest that the current P/E ratio on the S&P 500 is approaching a long run average, which suggests that further upside for equities may be more difficult in the weeks ahead.

What now? So far markets have reacted to the fact that economic conditions are the past the worst and the reaction has reflected less negative economic data releases, with many data releases coming in ahead of expectations. Going forward, it will require actual positive news as opposed to less negative news to keep the momentum going. If positive news is lacking the improvement in risk appetite and equity market rally will falter, especially as valuations are arguably far less compelling now.

I would be interested in your view about whether you think the rally will continue. Please tick the the relevant circle in poll on the sidebar to give your view and also view what others are thinking.

Posted in bank rescue, Bond markets, Commodities, Currencies, Economics, equity markets, Financial crisis, US, US administration. Tags: , , , , , , , , , , , , . 5 Comments »

Stress testing European and UK banks

May 8, 2009 — Mitul Kotecha

The US bank stress tests are finally over and markets are breathing a massive sign of relief. 10 out of the 19 banks tested will have to raise $74.6bn in equity but none of the 19 banks will become insolvent, with additional capital requirements deemed as “manageable”.

It hardly seemed worth getting all stressed up over the stress tests but the results are likely to prompt much debate about the methodology used and will not put to bed the issue of the health of the US financial sector and potential for even more capital raising in the future. This should be the theme of another post but for now I want to discuss what this means for European and UK banks.

The stress tests raise questions about whether the European and UK banking sector should follow the US.  The US administration has used the ratio of tangible common equity to total assets for its stress tests on US banks. This measure has been labeled as old fashioned but one that investors currently prefer. This is also the measure the IMF has used in its recent calculations to work our additional capital requirements for banks globally.

The IMF financial stability report estimated additional credit related writedowns in 2009 and 2010 at $550bn in the US, $750bn in the eurozone, and $200bn in the UK. The IMF estimates that the ratio of tangible common equity to total assets was 3.7% in the US at end 2008 but only 2.5% in the eurozone and 2.1% in the UK. It concludes that the extra capital needed to increase this ratio to 6% would be $500bn in the US, $725bn in the eurozone and $250 billion in the UK.

So will be there similar stress tests in Europe and the UK? The increased transparency that the stress test results have brought about in the US is good news for investors even if no bank was ever going to fail them but they raise a potentially worrying comparison with European and UK  banks which appear to have been far less forthcoming. The figures have been disputed by eurozone and UK officials but assuming the IMF is right the estimates raise some disturbing questions about financial sector health outside the US.

Posted in bank rescue, Economics, Europe, Financial crisis, US, US administration. Tags: , , , , , , . 5 Comments »

No “green shoots” in the jobs market

April 23, 2009 — Mitul Kotecha

 

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.

Posted in Economics, Financial crisis, US. Tags: , , , , , , , , . 2 Comments »
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