Groping the Elephant

Comment: Groping the Elephant

The disparate recent actions in the equity, bond and currency markets remind us of the off-color joke about the conclusions of three blind men who've happened upon different parts of an elephant. After recent consolidations and doubt about the way forward, last week, the stock, bond and currency markets all managed to seize upon their own theme and initiate decisive price action. The stock market shook off doubts about the economic recovery and rallied. Rather than sell-off as would be expected in an asset shift between bonds and stocks, the bond market managed to shake off doubts about inflation and demand for the copious supply and rallied. In contrast, doubts about the US dollar only intensified, causing the greenback to slide farther towards the lows from Sep'08.

~~~~~~~~~Signs of recovery boost equitiesAs expected, the data last week largely told the story of a global economy at least stabilizing, if not actually rebounding a bit. Not surprisingly, data out of Asia provided much of the basis for hope. China reported industrial production and retail sales data for August that exceeded expectations. Industrial production rose 12.3%y/y (consensus 11.8%), while retail sales jumped 15.4% (consensus 15.3%). Manpower surveys in not just China, but also Australia and New Zealand showed continued strength. Even Japan's leading indicators managed to beat expectations, rising to 83.0 (consensus 81.9), a high since Oct'08. Europe also managed to show some vigor. German factory orders for Jul rose 3.5% (consensus 2.5%), while UK industrial production surged 0.5% (consensus 0.2%) and manufacturing production jumped 0.9% (consensus 0.3%). The tone in the US was a bit more subdued, as the Beige Book provided cautious optimism that the US economy is leveling out and even showing some signs of recovery. The S&P500 climbed to a high of 1048, its highest level since Oct'08. Remember that prior to the Lehman collapse, the S&P had been struggling to hold above 1200, so one could make the case that the equity market remains in the process of unwinding Armageddon.

~~~~~~~~~Economic weakness, strong demand boost bonds

Rather than sell-off on the equity rally, US Treasuries rallied during the week. While the price movement was odd in the context of the equity rally, it did have support in other developments.

Not all economic reports showed signs of the economy leveling or even recovering - others showed that any recovery remains quite fragile and weak. US inventories, which economists, based on previous post-WWII cycles, are expecting to rebound "anytime now", continue to fall more steeply than expected. In Jul, they fell 1.4% (consensus -1.0%), and they have fallen more than expected in 8 of the last 11 months. The conventional, positive spin is that the sharp drop will lead to a sharp rebound as demand returns, but that eventuality is being called into question. The inventory-to-sales ratio is coming down (latest is 1.23), but the ratio is still months away (at least Q4) from reaching a level more consistent with inventory builds. Since 2003, the lows for the ratio have been between 1.1 and 1.6.

Yet more reason for doubt about a strong rebound comes from the consumer. The census bureau reported that during 2008, the median household income fell 3.6% to its lowest level (in real terms) since 1997 and that the poverty rate rose to 13.2%, a high since 1997. And more recent data also shed doubt on the ability of the vaunted US Consumer to mount anything like a powerful rebound. Consumer credit collapsed by $21.6bn during July. Easily a nominal record due to inflation and the secular increase in credit in the years up through 2007, the contraction was also extraordinary when transformed to offset those factors. The 12-month moving average of the m/m % change has dropped to -0.3%, easily a record in data back to the 1950's. The prior worst figure was -0.1% in the early-90's, and the only other negative print was in the mid-70's.

Not all the poor news came in the US. German industrial production for Jul unexpectedly fell 0.9% (consensus +1.6%), while Canadian building permits collapsed 11.4% (consensus +0.4%). And Asia experienced some bad news, too. In Australia, retail sales unexpectedly fell 1.0% (consensus +0.5%), and employment fell more than expected (-27.1K versus consensus of -15.0K). And finally, Japan's Q2 GDP was revised significantly lower from 0.9% to 0.6%, and its machine orders fell 9.3% in Jul (consensus -3.5%). A universal concern is the degree to which positive growth data is evidence merely of government spending programs rather than organic, sustainable growth.

Another theme supporting US Treasuries was strong demand for the copious amount being auctioned by the US Treasury. Despite $70bn in auctions this week - $38bn of 3yr notes, $20bn of 10yr notes and $12bn of 30yr bonds - investor demand remained more than adequate, with the auction yields below primary deal expectations in all cases. Anecdotal information suggests that Asian buyers, particularly the Chinese and even traditional Japanese entities, are supporting the market. With the Fed on pace to step away from its Treasury buying program by the end of October, such demand is critical to keep bond vigilantes at bay.

~~~~~~~~~Currency market pushing for a new currency regimeWith US equities higher and US bonds higher, the US dollar must have increased - right? Wrong. The "third blind man" was obviously grasping a different part of the elephant and concluded developments warranted a different, and in our view - much darker - conclusion about the world. The week started off with not only with Asian equities rising, but a Chinese leader declaring that the US policy of extravagant spending was cause for deep concern. These two factors pushed already jittery traders and investors to resume sales of the greenback, which ended up falling against all major currencies on the week.

The market appears to be looking for any and every opportunity to abandon the US dollar. In particular, during recent months, any signs of global strength, usually equity rallies, have given rise to broad-based US$ selling. The correlation of the S&P500 has experienced a broad and strong correlation with the various major currencies against the US$ over the past 2 months. The CRB commodity also remains significant for all major currencies. The prices of oil and gold continue to exhibit a significant correlation for most major currencies. Absent from consideration for all currencies is any consideration of central bank target rates.

However, as we have stated on numerous occasions, while we might dislike US policies, we cannot simply unload the country's currency, as such a sell decision always entails a buy decision of another currency. The currency market is unlike the stock or corporate bond markets, which an investor can exit altogether (i.e. go to cash or Treasuries). With currencies, you've always got to own one. Even if you buy commodities, you're generally transacting in US

Unfortunately, the strength of other currencies is beginning to attract negative attention from the policymakers of other countries. The BoC noted the risks to both growth and deflation from a too-strong Loonie in its rate setting statement. The RBNZ's Governor Bollard expressed concern about the strength of the Kiwi in a speech earlier last week. We do not believe other currencies at current levels present attractive buying opportunities. But trying to bet on the US$ when so many others continue to clamor for its demise represents a dicey proposition.Asset Outlooks

1) Equities: Equities could very well continue to grind higher given that they have not yet completely unpriced Armageddon. 1200 on the S&P500 would arguably represent the complete unwind of concerns about the financial collapse. We do not believe that such a level is sustainable, as in early-Sep'08, equity investors conceded an economic slowdown and a couple black swans lurking, but had not yet begun to price in the full impact of deleveraging on the real economy and profits. Our favorite tactic right now is to sell out of the money calls on long equity positions. More conservative investors might consider collars.

2) Eurodollars: We remain long the Mar'10 eurodollar futures contract. The market has retreated substantially from calling for hikes by Mar'10 (less than 50% priced in), but there's still some profit left in such a position. The calls for hikes further out in 2010 become more questionable. Unemployment is likely to be waning by mid-2010, which has in past cycles been the point after which the Fed begins hiking its target rate. However, a Taylor rule estimate based on the consensus outlook for core PCE inflation and unemployment doesn't suggest Fed hikes until at least 2012. Furthermore, the myriad non-traditional easing programs implemented by the Fed provide other opportunities for more pinpointed removal of accommodation before wielding the rough hammer of the interest rate target. More aggressive economic bears will find suitably profitable positions in long Eurodollar positions further out the curve.

3) Treasuries: Curve flatter. The curve has flattened in light of anecdotal evidence of strong foreign demand for Treasuries at the 3yr, 10yr and 30yr auctions last week. The combination of demand matching supply and the soft and non-inflationary economic data should help keep the long end of the curve contained. The front end of the curve remains pinned down by reasonable soft data and dovish, soothing Fed rhetoric. We remain of the view that the curve has reached its steepest point for this cycle and that normalization will entail a flattening (we have a 2s10s flattener on) over the next 3 to 6 months.

4) FX: The dollar keeps on sinking, and investors / traders with short USD positions, particularly versus the NZD and AUD, should keep those positions on. However, we would not add to those positions. Rather we would be looking to lighten up on such exposure, whether by taking partial profits, writing out of the money calls or establishing collars to protect profits.