Saturday, March 16, 2013

March 16: from Bear Stearns (2008) to Cyprus (2013)

European leaders' decision to impose losses on depositors in Cyprus banks may be ominous for the region's the same fashion that Bear Stearns' collapse foreshadowed the Lehman events a few months later.

Politicians' credibility is getting ever weaker in Europe...but the 'blunders' keep coming:

- Deauville in October 2010; Merkozy 'agree' on imposition of losses on the private sector, only to show 'regret' at a later stage.

- Denial over the need for Greek debt restructuring ('re-profiling' was first timidly suggested as an option as late as in May 2011).

- Distorting the meaning of 'voluntariness' (e.g. voluntary buyback of Greek debt in Q4 2012).

- Cyprus deposits.

Why is the Cyprus decision a blunder?  Some first thoughts:

1.  Over and above the catastrophic consequences for confidence in Cyprus, it introduces huge uncertainty for depositors in other periphery countries. Even the 100k euro deposit 'guarantee' is getting scrapped 'at will', shaking the foundations of confidence in the eurozone banking system, in general. Commissioner Rehn's assurances are simply not 100% credible; and anything less than 100% credibility will not work in such situations. Banking stability risk is again on the table, and visibly so, while a 'banking union' still remains far in the horizon.

2.  It is a move that is likely intended to convey a 'hard-line' political message regarding austerity program implementation, esp. in Greece (dragging its feet regarding public sector layoffs). But this is a time when consensus seemed to be getting more open to a 'softer' stance on the pace of austerity policies, which have so far had 'self-defeating' results (low tax revenues, high unemployment, etc.)

3.  If making a point on money-laundering (i.e. Russian funds) was at the heart of European leaders' motivation, then, at the very least, 'horizontal' deposit haircuts are too blunt a tool to communicate such intentions. 
The average working-class depositor is being treated very unfairly; and it should not matter that Cyprus represents only 0.5% of the Eurozone GDP (the issue is qualitative).

4. This was certainly no last minute move on the part of Germany. Mr. Schaeuble's view that a bankruptcy in Cyprus would not present a source of systemic risk was reported in the press as early as January.

For example, Der Spiegel reported on 28/1/2013: 

The head of the European Central Bank, Mario Draghi, warned German Finance Minister Wolfgang Schäuble last week not to dismiss Cyprus as not being 'systemically relevant' and said a failure to bail out the island nation could threaten the wider euro zone.....

...Draghi was backed by the European Economic and Monetary Affairs Commissioner Olli Rehn as well as the head of the European Stability Mechanism, Klaus Regling....

...The three pointed out to Schäuble that the two biggest banks in Cyprus had a large network of branches in Greece. If any doubt were cast on the safety of deposits held with those banks, the uncertainty of Greek savers could quickly spread to Greek banks, which would represent a major setback for Greece.

It seems the German side was merely content to exclude Cyprus banks' greek branch deposits from the 'haircut', thinking that this would make things alright. 

This is clearly dangerous, short-sighted thinking, illustrative of the lack of leadership in Europe at the moment.  It also reminds me of the excess zeal with which rating agencies tried to regain credibility following their demise during the financial crisis by 'overcompensating'  during the Eurozone debt crisis ('strict' downgrades/commentary); ironically, this often also acted as an amplifier of the crisis.

Importantly, we seem to have reached the limits of solidarity and the edges of 'self-preservation' in the Eurozone, as economic recession is at Germany's door.

So the stance on Cyprus may be a harbinger for what may follow in policy space. This is

of systemic importance.

Of course, elections are also playing a role, as usual. Mrs. Merkel would surely like to show that she is (finally) standing up for the German taxpayer after all...before the autumn.

No doubt the Cyprus decision will have consequences; history reaches us that 'systemic' is dynamic....what may have appeared as small/inconsequential may have huge impact, in unforeseen ways.

Unfortunately, it might not take many more blunders to set off a chain of social disruptions that will prove hard to contain and have deep impact on Europe's future.

The time is now for initiatives such as the fiscal compact, banking union, etc. to start taking shape. Assuming, of course, that was the real intention of those who signed the agreements (if they themselves ever had a clear view on this, one might add...)

* * * * * *

As an aside: this news serves to highlight the common thread throughout the global financial crisis: a deepening polarization between, one the one hand, (uninspiring) governments / the 'elite' and, on the other, the middle/working class population:

1. 'Too big too fail' bank bailouts, using taxpayer money.

2.  Quantitative easing relied on as the only stimulative policy response.

- Beyond QE1 (necessary existentially) and, maybe, QE2 (deflation threat, signal that the Fed is 'present'), subsequent rounds of Q.E. have largely been enacted in order to 'replace' a confused/inadequate fiscal/political side.

- Monetary stimulus has not really found its way to the real economy, basically benefiting the financial side: asset market players, banks and corporations (reflected in record stock buyback activity). 

- Monetary policy cannot act as a substitute for fiscal and supply-side policy; the fact that central bank stimulus has 'worked' in avoiding an economic meltdown does not mean that it can be relied upon indefinitely (although this would certainly offer a kind 'wishful thinking' kind of convenience to elected leaders).

- As a result, we have been witnessing an essentially 'time-inconsistent' debt-reduction urge among the political class (a 'post-traumatic' shock reaction, in the midst of a balance-sheet recession).

So, in all, savers have been getting hurt both directly and indirectly; but the Cyprus decision is outright blunt, taking the 'game' to a whole new level (for example, see what The Economist says on the news).

Monday, February 11, 2013

US materials sector: second thoughts?

This research note was prepared on December 12, 2012

US materials stocks have been underperforming the S&P 500 for the better part of this year. The latest reporting season (Q3 2012) exacerbated an already heightened sense of pessimism toward the sector, with negative y-o-y earnings (-23.6%) and sales (-6.4%) growth that broadly trailed consensus expectations. Predominantly negative guidance compounded the adverse reaction to earnings misses, with most companies citing a challenging commodity pricing environment as their key concern[1]. Analysts have thus proceeded to revise estimates sharply downward for the upcoming quarters.

However, a closer look at global macro, earnings, valuation and technical considerations currently calls for reviewing the investment case for US materials stocks versus the S&P 500. Looking ahead, the path of least resistance is higher for materials equities relative to the broad market.

Gloomy sentiment is not without grounding
The trajectory of global economic growth certainly leaves a lot to be desired, implying relatively weak prospects for deep cyclical sectors (US materials included), which are intimately tied to commodities and sensitive to shifts in global trade dynamics. Global demand for basic resources has not been as robust as in previous years. At the same time, more ‘structural’ supply has been steadily flowing into base metal markets, chiefly in response to China’s rapid growth during the last decade; the fact that major global mining players (e.g. BHP, Rio Tinto) have been shelving or trimming down capital expenditures signals that this supply/demand imbalance is starting to ‘bite’.

Macro considerations
While the Eurozone crisis’ ramifications have gradually come to be ‘digested’ (for the time being), the current policy mix implies that the region is slowly, but surely, heading deeper into recession. The US economy has been showing relative resilience, but real GDP growth is expected to remain sluggish (yet positive) and the looming ‘fiscal cliff’ brings back memories of summer 2011 (is politically-induced uncertainty of the ‘Knightian’ type, after all?). Meanwhile, debate about which variety China’s landing will take (‘soft’ or ‘hard’) has been rampant. Still, what most investors agree on is that there is a landing; China’s commodity-intensive growth has taken on a slower pace over the last eighteen months—not least a corollary of the central government’s emphasis on arresting (socially destabilizing) inflationary pressures.

However, the skies may be getting clearer. There are signs Chinese economic activity is bouncing off a cyclical bottom. Infrastructure project spending has been picking up (with the blessing of the authorities), so the fiscal tap is getting ‘looser’. Monetary policy indicators are also suggestive of easing financial conditions, with broad money and credit growth aggregates showing improvement (chart 1). In addition, a wide array of data has started to surprise on the upside (e.g. November industrial production +10.1% y-o-y, the best reading since March) and important leading indicators point to ‘expansionary’ territory (e.g. official PMI manufacturing at 50.6 for November; chart 2), signaling that the economy may be turning the corner.

Chart 1
                                            Source: The Australian Economy and Financial Markets, Reserve Bank of Australia,
  December 2012.
Chart 2
A crosscheck with non-Chinese statistical data seems to confirm this positive momentum. The commodity-heavy Australian stock market remains on a rising trend versus global equities since the summer correction (in USD terms; chart 3 on the next page), the CAD and AUD remain resilient (while the RBA reduced its policy rate to 3% last week, the AUD/USD actually moved higher on the news, with investors likely pricing in a pause in coming months) and select commodities are picking up steam.
Chart 3

Indeed, segments of the commodity market whose terms China ‘dictates’, such as iron ore (chart 4), have rebounded considerably since bottoming out in September. Copper, which correlates well with trends in global growth, has also rallied significantly (up 7.3% since the November lows; chart 5 on the next page).
Chart 4

Chart 5

Turning to the US, improving (albeit slowly) labor market conditions, a recovery in housing trends (e.g. housing starts) and a relatively strong auto sales dynamic (replacement demand) lend support to GDP growth going forward—notwithstanding persistently weak real household income growth and nascent corporate capital expenditures (the latter could see a rebound in 2013, provided the ‘fiscal cliff’ is averted thus reducing policy uncertainty).

Meanwhile, the US dollar is expected to remain under pressure on the back of the Fed’s ‘open-ended’ accommodative stance, acting as a tailwind for commodity prices.

In sum, key macro variables—improving leading indicators, recovering commodity prices, bright spots in US economic activity and a supportive currency regime—seem to be turning up, giving reason for optimism.

Earnings fundamentals also point to a better outlook for the US materials sector.

As discussed above, global cyclical conditions, positively correlated with important earnings growth drivers for the US materials sector, currently bode well for profitability. The pending re-acceleration in Chinese output should buoy end-demand for basic materials. Furthermore, higher commodity prices are expected to enhance pricing power, while ample global liquidity and a favorable (policy-driven) USD bias should provide a boost to sales and the bottom line, as long as the industry’s cost structure remains in check.

In this respect, gauging the health of the US chemicals industry is crucial to understanding the overall sector’s prospects, as it comprises around 70% of total market capitalization. These companies enjoy a competitive operating cost advantage arising from the use of natural gas in production, benefiting from the sizeable differential in US prices versus the rest of the world[2]. The shale gas ‘glut’ has pushed US natural gas prices dramatically lower and this ‘game-changing’ theme is likely to persist for the foreseeable future.

Relative valuations for the US materials sector are compelling—the 12-month forward price-to-earnings ratio trades at a modest premium to the broad market, while its dividend yield at 2.5% (fourth highest among the ten major S&P 500 sectors) remains above that of the S&P 500 (chart 6). Moreover, analyst earnings revisions have arguably discounted a lot of negativity—certainly a notable contrast with consensus in early 2012 (chart 8 on the next page). Adoption of a contrarian stance may be getting increasingly appropriate for investors at this juncture, as the combination of a low relative P/E ratio and depressed relative 12-month forward EPS expectations suggests a good amount of pessimism may already be priced in.
Chart 6
                                            Source: Goldman Sachs 2013 Equity Outlook, November 28, 2012.
Chart 7
                                            Source: Goldman Sachs 2013 Equity Outlook, November 28, 2012.

Chart 8
                                            Source: Goldman Sachs 2013 Equity Outlook, November 28, 2012.
In contrast, the relative valuation metrics for domestically oriented industries such as utilities, consumer staples and telecom services have become ‘rich’ (charts 6 and 7 above).

These sectors’ ‘low-beta’ nature and relative cash flow stability (attractive in an environment of lackluster economic growth), coupled with strong investor demand for dividend income (‘search for yield’ theme) have led to substantial investor inflows.

The looming risk of higher dividend taxation in 2013 could, at the margin, bring about a short-term negative impact, but ‘repressed’ bond rates (and negative real yields globally) render this trend unlikely to meaningfully reverse any time soon. Successively lower bond yield levels have made equities an increasingly attractive ‘income’ play. Chart 9 illustrates this point, showing the clear downward trend—interrupted by ‘risk off’ periods—in a ‘bond/dividend stock’ ratio proxy[3] (IEF/DVY; plotted against the 10-year Treasury yield[4]).
Chart 9

Still, from an overall valuation perspective the risk/reward tradeoff favors a gradual rotation away from defensive sectors and toward more cyclically exposed industries.

Market signals / technicals
Finally, what is the message from the market? Price action across asset classes following the much-anticipated launch of QE3 speaks volumes: the S&P 500 failed to stage a sustainable rally (‘buy on rumor, sell the news’?), while the USD strengthened, the 30-year Treasury yield moved lower and market-implied inflation expectations actually declined after a short-lived spike. This could be signaling ‘reflation failure’ (maybe it is not the markets that react to central bank action these days, but the other way around…)

Indeed, gold mining stocks (GDX), a useful gauge of the market’s reflationary pulse, have underperformed the S&P 500 (SPY) by 14% since the Fed’s QE3 announcement (chart 10). This could be taken as another manifestation of ‘exhaustion’ in the stock market, notwithstanding idiosyncratic factors that are weighing on this particular industry (e.g. relating to operating cost pressures, writedowns, et al.)
Chart 10

Importantly, the implicit message from the US equity market—reinforced by relatively ‘stretched’ valuations in domestically exposed sectors—seems to be that, for a move toward new highs to materialize, it is the deep cyclical sectors that need to ‘pick up the baton’.

Interestingly, the underperformance of Emerging Market equities (EEM) versus the S&P 500 (SPY) since Q4 2010 appears to be running out of steam, lending credence to this view. This can be seen in conjunction with the observation that US economic resilience has by now largely become consensus among investors (unlike 12-18 months ago), whereas perceptions of (China-led) improvement in Emerging Markets’ growth prospects continue to be dominated by skepticism. Resolution of this ‘divergence’ could provide the fuel for a continuation in the EEM/SPY ratio’s recent positive turn, potentially foreshadowing outperformance for the US materials sector (XLB) versus the S&P 500 (charts 11 and 12).
Chart 11

Chart 12

Looking at technicals, the XLB/SPY ratio has traded in a tight range since Q2 2012 and seems likely to ‘exit’ sooner rather than later; a move higher in the EEM/SPY ratio augurs well for this breakout to occur to the upside. What is more, the 50-day moving average is on the cusp of crossing the 200-day moving average line from below (‘golden cross’), for both ratios (EEM/SPY as well as XLB/SPY), a positive near-term signal.

Also, Chinese property stocks have been on the rise (+20% year-to-date), significantly outperforming the (rebounding) broad Shanghai Composite index (chart 13 on the next page). This is potentially a bullish development for the relative performance of US materials stocks, as it tends to correlate quite closely with the relative performance of the Shanghai Property index. This ‘link’ likely reflects the influence of Chinese real estate trends on commodity demand and perceptions thereof.

Chart 13

The main risks to this analysis arise from potential failure in ‘fiscal cliff’ negotiations (hence likelihood of a US ‘growth scare’ and ensuing global risk aversion), disappointment coming out of China (e.g. the new leadership does not provide enough stimulus, cyclical growth indicators roll over, there is an outburst of inflation, et al.) or a flare-up in the Eurozone’s sovereign debt crisis that may lead to a global ‘risk off’ phase.

In addition, one needs to remember that China’s aspirations for economic rebalancing are unlikely to be a ‘free lunch’ (as is true of any adjustment) and should, in all probability, lead to a lower real growth rate along the process (the exact timing/specifics are admittedly a political decision). Nevertheless, the cyclical backdrop currently suggests that there is scope for near-term growth acceleration in China.

A case can be made based on a combination of macro, fundamental and technical factors for viewing the US materials sector through a more positive prism in terms of relative risk/reward. From a contrarian standpoint, the current divergence between the Street’s negative consensus stance, on the one hand, and this analysis’ more constructive tone, on the other, suggests that it may be prudent to book profits in domestic/defensive US sector positions and gradually rotate toward more globally exposed, deep cyclical sectors—particularly US materials equities.

[1] Source: Factset Earnings Insight, November 30, 2012.
[2] For example, see Europe’s fears over US energy gap, Financial Times, November 9, 2012.
[3] Not intended to represent the stock-bond ratio, which is calculated on a total return basis, but to reflect investors’ attitudes toward the relative attractiveness of US Treasury bonds versus (dividend-paying) equities.
[4] TNX is an index tracking the 10-year nominal Treasury yield.