Market complacency may be its undoing

Welcome to the Q1 reporting season. If you hadn’t noticed yet, Easter came early this year (good for retailers, airlines etc) and there is a minefield of shifting currencies and commodity prices to adjust for as well as some decidedly mixed macro data coming out from the major trading economies.  If you’re selling out of a Euro manufacturing base or consuming a lot of energy, then chances are that Q1 2015 is proving a relatively benign results season. For those outside of this magic circle, then perhaps one should think beyond the share buybacks and start applying cheap capital to leverage cost synergies through acquisitions. Fedex buying TNT, Heinz buying Kraft Foods and Shell buying BG are all manifestations of this process.

In a World dominated by QE and its accompanying financial repression and currency wars however, none of this really matters. As long as governments and central banks can sustain the illusion of endless liquidity without flipping their currencies into free-fall and hyperinflation, real price discovery will continue to be crowded out by the carry-trade junkies in what is increasingly a zero sum game of beggar-thy-neighbour. Unfortunately, as with any hard drug addiction, this is a habit that is going to prove difficult, if not impossible for politicians to kick.  The consequence of US tapering of QE has been a rise in US dollar and fall in commodity prices as liquidity supporting these asset classes dried up. While the latter has been supportive of domestic consumption, the former has monkey-hammered US GDP growth expectations and with it China, as recent March trade data highlights. In our new world order where good news is bad and the reverse also applies, then falling growth can only mean one thing, the spice must flow again. Forget an early US interest rate increase and indeed brace yourselves for the taps to be opened again. With record oil stocks and the prospects for yet more excess supply to arrive following a possible rapprochement with Iran, why else have oil prices rebounded against this backdrop of falling GDP expectations?

Perhaps perversely, the market’s attempt to discount such an eventuality may be its very undoing. If asset prices remain elevated in the anticipation that the falling GDP expectations will necessitate QE4ever-wherever, then what is going is going to provide the catalyst and political cover for the Fed and PBOC to defer its rate increases and possibly engage in a little surreptitious pumping? Clearly a market dump will need to be engineered first which may well also explain the self-interested warnings from some leading Wall Street banks that a correction may on its way.  As the instructions say, “Rinse, repeat”.   

Markets find it tough to break the BTFD conditioning

Was the Friday rebound in equity markets another BTFD opportunity, or a possible suckers rally? Certainly, the wall of central bank liquidity over the past five years have reduced the market’s pricing mechanism to little more than a pavlovian response to the next turn of the central tap and where bad news can be good news for prices if it raises expectations of a bigger flow.  News however, whether good or bad that does stimulate more liquidity may just be bad news.  

Last week had a lot of ‘bad’ news. This however was not new bad news. The US continues to goad Russia, albeit now through bombing its ally Syria and getting its own ally Saudi Arabia to cut oil prices on which Russia also depends. Ebola continues to spread, which is bad for airlines, but good for pharma and security. Japan continues to struggle with radiation, a collapsing economy, rising real inflation and what should be an utterly discredited and failed QE policy.  Europe meanwhile continues to grind back into recession, but having approached the moment of truth may be shying away from the full QE programme that advocates were predicting after Draghi’s recent Jackson Hole speech.  Notwithstanding a partial attempt with an ABS programme, this fell short of expectations and so bad news was just bad news and markets reacted accordingly.

Unfortunately, market volatility is an inevitable consequence of the deliberate confusion about the nature of the ECB and Euro that has been sponsored by politicians and central bankers. At the centre of this has been Merkel who has been trying to ‘hunt with the hounds and run with the hares’.  EC treaties are clear and indeed have been paid lip service to by Draghi when he re-iterates that the EC is “not a transfer union”.  His actions however belie this, including advancing ECB liquidity to domestic banks who have used this to buy local sovereign debt in the secondary market to circumvent the ECB’s prohibition to fund primary debt. Notwithstanding the German constitutional court’s ruling in February (which had been sat on for around 9 months) that the ECB’s OMT plan “manifestly violates” the EU treaties, Merkel seems happy just to turn a blind eye while playing a ‘good cop, bad cop’ game with Bundesbank president Jens Weidmann.  This, together with Draghi’s “whatever it takes” and subsequent utterances have goosed the market into believing peripheral EU sovereign debt is now backstopped by the ECB and therefore German tax-payers. German tax-payers however have not been consulted and seem to be in no mood to comply, as today’s comments from a key Merkel ally, Hans Michelbach of the Christian Social Union (CSU) might suggest. Not only is Draghi accused of “endangering the stability of financial markets”, but more pertinently Herr Michelbach reminds us of the now largely ignored constitutional court ruling and that “The ECB needs to change its policies so that they come back within the terms of the treaties”

http://uk.reuters.com/article/2014/10/04/germany-ecb-draghi-idUKL6N0RZ07N20141004

So bad news in Europe may not be the ‘good’ bad news that markets have run with during the US QE programme, but ‘bad’ bad news for markets if the ECB is approaching that crisis point where it has to reveal whether it has any real bullets in its monetary pistol or has just been fooling us with blanks. Perhaps by taking Europe to the cliff, Draghi feels he can present the German tax-payers with a fait-accomplie from which they dare not refuse, as such a refusal would have devastating consequences to peripheral bond markets and banks. Germany’s decision however, will not be telegraphed to us muppets ahead of time. With peripheral Euros now invested back into peripheral bonds and banks, the creation of a hard currency Northern block at this stage would not be saddled with a mountain of peripheral euros in Germany which might have to be converted at par into the new Deutschmark. While the ‘soft’ Euro areas would then be free to monetise debt and devalue, yields would rise significantly and there would be no shortage of burnt positions amongst bond investors.

So what was the cause of Friday’s market euphoria, a cure for Ebola, peace on Earth? No, it seems a slightly better than expected monthly job growth figure in the US non-farm statistics for September.  To qualify as a ‘good’ figure for markets however would either be a really ‘bad’ number that would raise the prospect that Yellen would defer the QE tapering and keep the liquidity tap and low rate environment going indefinitely or a figure that was so good as to signal a serious acceleration in US GDP growth prospects. Unfortunately neither of these would apply to the September numbers. At +248k net new jobs (+236k private), US job growth was around +30k ahead of consensus and the trailing 12 month rolling average of approx. +213k, albeit in large part reflecting a +40k MoM swing in retail (from -4.7k in August to +35.3k in Sept).  While the numbers are ‘so..so’, they do not deserve the praise heaped on them by political spin doctors who focussed on the flawed unemployment ratio (-0.2ppts to 5.9%). 

Perhaps a little perspective is needed for this political hot potato. First, the context. For the year to end September, US private sector employment increased by +2,588k/+2.25% to 117.524m versus a total civil non-institutional population that increased by +2,278k/+0.93% to 248.446m.  This is hardly spectacular given the government and central bank largesse over the period with private sector job growth only just exceeding population growth. But what about incomes?  Average hours have barely changed at 34.6 pw (vs 34.5 pw) while average hourly earnings are struggling to keep pace with inflation with a +2.0% YoY increase to $24.53 p hr (from $24.04 p hr) to take average weekly earnings from $830.07 pw to $848.74 pw, an increase of +2.2% YoY.  Multiply this by the increase in employment and this implies that private sector wages increased by +4.6%/+$225.8bn to approx. $5.2tn. Although this may seem ok, there are a couple of points one may need to consider. Firstly, don’t forget that the private sector ultimately has to support the entire working population and that these figures are nominal. Also, remember that the US economy is worth approx. $17bn pa, which means that the $225.8bn increase in private sector wages is equivalent to only +1.3% of GDP.  If consumption accounts for around two thirds of GDP in the US, clearly private sector wage growth alone will not be offering much of a boost this year!

So back to Friday’s market bounce. As the dog might utter, “Woof, Woof”