The risk-on trade has received a new lease of life as a result of somewhat better economic data coming out of the US and some (probably misplaced) excitement over the political leadership changes in Greece and Italy.
Trying to cut through the fog we come up with the following observations:
The US equity market is characterised by high volatility and a lack of direction. For now the S&P 500 is stuck in a trading range between 1220 and 1270. The 200-day moving average, which is at the upper end of the range, has proved to be a formidable resistance level. Most rallies occur on low volume which is a sign of a lack of conviction by investors.
There are some near-term positives, however.
From a seasonal perspective we are entering a time period which historically has seen relatively strong price movements on the upside.
We may see a traditional Santa Claus rally for several reasons. Hedge funds are very underweight and most of them missed the October rally. Since their cash levels are relatively high they may well want to increase their positions before year-end. Another reason why this rally could continue for another four to six weeks is the increased hope for QE3 sometime early next year.
Although economic data has come in somewhat stronger than expected as of late, we do not think that recession risks are off the table.
Every US recession in the past came after a financial or economic shock. This year we had one in late summer triggered by the Euro zone debt crisis. The economy tends to turn down with a time lag. Looking at the recessions following financial shocks in 2007, 2000, 1990, 1982 and 1980 there has on average been a nine-month time lag for the economy to slip into recession.
Looking at 2007 investor sentiment was similar to today. There was a lot of hype about the Fed coming to the rescue by cutting rates. GDP growth was resilient at 3% in the third quarter of 2007 (this year third-quarter growth was a relatively robust 2.5%). Financial stocks were down 20% in 2007, just like today, and US Treasury yields were declining sharply, just like today.
While GDP in the fourth quarter of 2011 might come in at 2.5%, the main concerns are about the first quarter of 2012.
Fiscal restraint at the state and local level will provide strong headwinds for the economy going into next year. Furthermore, economic activity in Europe has slowed considerably and numerous indicators point towards a recession.
The US and the European economies are highly correlated and it is unlikely that one goes into a recession while the other one does not. After all, 20% of US exports are going to Europe and 20% of the top 100 US companies’ earnings are coming from Europe.
Even if the equity rally extends a bit further than we originally anticipated, we have not changed our view to reduce equity positions into this rally.
While corporate earnings have been robust, growth momentum is decelerating with the number of downward revisions outpacing the number of upward revisions. Equity prices are very sensitive to earnings revisions.
It would be naive to assume that the caretaker governments in Italy and Greece led by economists will be more effective than their predecessors in pushing through austerity measures.
Italy’s refinancing requirements next year are a massive EUR200 billion. So far, the ECB has been resisting calls for unsterilised bond purchases. According to Article 101 of the Lisbon treaty, which came into force on 1 December 2009, the ECB is specifically prohibited from lending directly to European governments.
The ECB purchases have taken place in the secondary market and at least up to now have been sterilised.
The ECB bought EUR9.5 billion worth of Euro zone government bonds last week, up from EUR4 billion the previous week. The bulk of it was reportedly in Italian bonds.
For the ECB to act as lender of last resort and to embark on unsterilised bond purchases (QE) it would take to repudiation of the EU treaty. The ECB is still holding out. For how much longer they will do so remains to be seen.
It is also interesting to see that there is now open talk about a two-speed Europe, and of countries like Greece leaving the Euro zone. So far this has been a taboo among the policy elite in Europe. Watch this space!
Our recommendations against this backdrop are:
High dividend yield stocks, consumer staples, utilities, gold miners
US Treasuries and high-yield corporate bonds (the latter have been hammered and look attractive; a recession is already priced in)
Gold, silver (physical, ETFs and gold mining shares)