Thursday, July 23, 2009

Market Update: Near-term risk-recovery not over yet

The recovery in risky assets remains in full swing whereas the correction in government bonds is ongoing even though in comparison it is relatively shallow. While I have been expecting this risk-recovery period to be over by the end of this month (see for example Market Update: Temporary countermovement), there is a clear risk that it might last a few days longer. However, in line with my near-term growth outlook, I still expect this period to be a temporary one with a deeper correction in risky assets into autumn and winter.

Equity and credit markets continue to be the driver of risk recovery. Broadly speaking, credit spreads have tightened back to their early June lows while equities are back to their early June highs. However, regionally there are some significant differences. For example, the US Nasdaq and Dow Jones as well as the Swiss SMI, the Spanish IBEX or the Swedish OMX have all surpassed their early June highs on a significant basis. Others, for example the DJ Euro STOXX50 and the UK FTSE are almost exactly at the highs of early June while a third group such as the Nikkei or the Brazil Bovespa fall short of the early June levels. Commodities on the other side remain lagging and for example the CRB-index has only recovered approx. half the losses it incurred since mid June, trading some 7.5% below the June highs.
Technically, most markets do not seem overbought yet and also the fact that a growing number of equity indices is making new highs suggests that the upward movement can continue in the short term. This would fit with apparently still high cash levels for a large part of institutional and private investors as well as improving near-term growth prospects and the news so far regarding Q2 earnings. According to Bloomberg, 76% of the companies out of the S&P500 which have reported earnings surprised positively vs. consensus expectations. As Bloomberg states: 'Despite a 6.4% drop in earnings for companies that have announced their results, firms in aggregate have exceeded expectations by 16.1%. Financials has beaten analyst projections by the widest margin.'
Credit spreads back at early June tights...
...Equity markets back to approx. early June highs...
...wheras commodity markets lag in performance...
...while correction in government bonds is ongoing but relatively shallow
Source: Bloomberg

However, despite the short-term risk recovery, my strategic asset allocation outlook remains cautious. As I laid down in Q3 growth likely to surprise positively but not final sales while near-term growth prospects look positive indeed, this is not the case for final demand and the growth rate should move lower again into autumn and winter, further aggravated by the rapidly rising risk of a swine flu pandemia in the Northern Hemisphere (see: Deflation due to swine flu?). Furthermore, I also see this subdued medium-term growth outlook being confirmed by the Q2 earnings season. To quote Bloomberg again: 'Revenue, excluding the Financials & Utilities sectors, is anticipated to be down 16.7% over the prior year. If the street consensus holds true, this will be the worst decline in the history of our database going back to 1994. Health Care is estimated to be the only sector to register an increase in sales.' If my impression is correct (sorry, but I could not find a hard statistic on this one), so far revenues vs. expectations has provided a mixed bag with several firms beating earnings expectations but falling short of revenue expectations. This to me suggests that more aggressive than anticipated cost-cutting exercises have been a key driver of earnings developments. It would also explain why the US unemployment rate has been increasing much faster than most anticipated even though Q1 (and most likely Q2) growth has not been much worse than expected. Furthermore, the divergence between earnings and revenue surprises explains as well the outperformance of credit and equity vs. commodities (i.e. still subdued growth in the demand for real assets).
Finally, as these cost-cutting exercises are performed on an economy-wide basis, they risk threatening the recovery as they lead to further weakness in final demand with a time lag. This is becausse the cost-cutting exercise of one firm is being mirrored by other firms' revenues or households' incomes being cut, leading to weaker future demand.

Overall, it seems that the near-term risk-recovery can run further which means that bond prices will also correct lower. While I previously expected this period to be over by the end of this month, there is a clear risk that it might last a bit longer. However, the medium term outlook remains subdued and a renewed period where risky assets and government bond yields move lower - most likely for a prolonged period with more pronounced losses - is likely to start sometimes during August. Therefore, I reiterate once again that I maintain my strategic defensive asset allocation stance but stick to a reduced risk taking on a tactical basis. The 120 area in the Bund future still looks as a good target to open/add to long duration positions.

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