Fed loosens, PBOC tightens, But ECB's bank 'serious' stress tests the big neglected story with the most potential to shake things up
The following is a summary of the conclusions of the fxempire.com weekly analysts meeting in which we share thought and conclusions about the key market movers, lessons, and noteworthy developments to watch for the coming week, moderated, recorded and refined into one or more weekly previews by the Chief Analyst, yours truly.
- Weekly Market Mover Summary
- Lessons and Conclusions: What to watch for the coming week and beyond
- QE Back, Markets Return To Pre-Taper Behavior
- ECB Bank Stress Tests Stressing Markets: THE Story To Watch - Carefully
- European Earnings Providing Limited Support For Stocks
- China: Credit Crunch Scare
- US Home Sales: As Investors, Not Owners, Support Housing Market - A Troubling Sign
- Q3 Earnings Mattered Somewhat, Influence Likely To Fade
WEEKLY MARKET MOVER SUMMARY
The below is a bullet-point summary of the full article.
- MONDAY: Earnings Both Good And Bad, Caution Ahead Of Belated US September Jobs Reports Dominate Monday Global Equities Trade
- TUESDAY: Once Again, Bad US Jobs Reports Are Bullish, Markets Rejoice
- WEDNESDAY: PBOC, ECB Take Over From Fed As Prime Move Markets
- THURSDAY: Technical Bounce Helps Asian indexes, Earnings Boost Europe And US
- FRIDAY: China Tightening, USD Weakening Hurt Asia, Europe, Earnings Boost US indexes
LESSONS & CONCLUSIONS
In our 2013 outlook from January, we concluded that barring some huge black swan event, the EU being the most likely source of that, as long as QE continued we didn't expect any major trouble in global stocks. Events thus far in 2013 have not contradicted this conclusion. Therefore:
The return of QE for the foreseeable future is the biggest lesson of the week, because the past years have shown that as long as it's in place, global stocks continue trending higher without the support of the normal fundamentals that support them - some combination of improving earnings and growth.
Were it not for the return of long term QE from the fed, news of the ECB bank stress tests would be the most important news of the week, because if done right, it will force either a resolution of the EZ debt and banking crisis, or begin the final chapter in the demise of the EZ as we know it. More on that and the rest of the lessons we learned for the coming week (and beyond) below
QE Back, Markets Return To Pre-Taper Behavior
Markets have now returned to their "bad news is good if it raises the chances of continued QE, long term risks be damned."
As we predicted last week here, we're back to long term continued QE and thus to our pre- taper market behavior that prevailed before May2013, due to a combination of:
- A new dovish FOMC head who will be less inclined to withdraw the liquidity and low interest rate support that props up risk asset prices and market sentiment
- Continued weak US economic data and earnings
- Additional economic damage from the US government shutdown
- Continued sequester (automatic spending cuts)
- Uncertainty about the ultimate resolution of the once-again deferred decision about how to resolve the US debt ceiling debate. This is likely to remain uncertain because the US electorate, and thus its elected politicians, remain undecided about how meaningfully reduce America's debt/gdp. Everyone agrees it needs to be done. The debate is over how to allocate the suffering between tax payers (paying more tax) and tax consumers (getting fewer services and lower benefits checks from the government).
That means all news is viewed as bullish or bearish mostly to the extent that it is believed to encourage continued QE.
Just like before last May, we're back to a QE addicted market in which moderately bad-to mildly good news is bullish because it keeps taper fears on hold.
What drives it is the belief that the usual positive fundamentals that drive stock prices higher, some combination of rising growth and earnings, well, they just aren't there. The latest jobs and earnings reports confirm this belief. Thus, continued QE as the only hope for rising risk asset prices.
Poor Jobs Report Supports Longer Taper Delay Good For Stocks Bad For USD
The convergence of the above negatives, along with a weak jobs report and earnings season means that over the course of two months we've gone from almost 100% certainty of a September taper to a new consensus of no meaningful taper for another 6-12 months.
So we're back to rooting for more bad news because markets have lost faith in the actual economy and think QE - government support - is the only hope for keep stocks aloft.
Ramifications of the Tuesday Jobs Report Going Forward
August NFP was revised up from +169 to +193K: That means the plunge from August to September was greater, that job growth may slowing faster than previously thought. That's a real possibility, considering:
- We've seen some large companies announce restructurings (aka firings). See here for details.
- Average hours and wages remain stagnant: the workers with jobs are not making more money. Considering that underemployment is believed to be above 15%. If we see consumer spending AND credit rise, especially as we approach the holiday retail spending season peak, we'll have another indication that the recovery is fading as spending is unsustainably fueled by credit rather than wages.
- The bad jobs report, combined with the delay to November 8th of the next monthly US NFP and unemployment reports, means that this dour jobs report was the last one the FOMC sees before its next meeting. Combined with uninspiring earnings and other data means the Fed remains dovish and that the chances for QE taper fade into mid 2014 at earliest, possibly not starting in earnest until late 2014.
- The latest NFP results confirm an ongoing downtrend in the number of new jobs the US is creating each month. Per Goldman Sach's Jan Hatzius: "The 3-month average gain in nonfarm payrolls is now down to 143,000, the weakest pace since August 2012. Other measures are even softer, with 3-month averages of 82,000 for total household employment growth and 42,000 for 'payroll-consistent' household employment growth"
The key point is that markets now believe QE is back to stay for a long time, and that explains why, using stock market indexes as our gauge (see here for why), risk asset markets as a whole remain near all-time highs. As we predicted in our forecast for 2013, stocks could continue to remain aloft without the help of improving underlying during 2013 just as they had in 2012.
Markets appear to agree.
"QE Trap" To Further Delay Any Meaningful Taper?
Ok, any taper discussion unlikely to even be up for discussion until well March 2014 at earliest, and even that would likely be an immaterial amount. Any genuine cuts in QE, and concomitant rising rates, are unlikely until late 2014, with QE continuing into 2015.
That's assuming of course, that once the Fed sees enough growth to justify a QE withdrawal, it can figure out how to pull it off without causing a spike in interest rates that endangers that very recovery and drives the Fed to backtrack, as it has recently done.
However it's far from clear how or when the Fed will be able to do that.
In late September Nomura Bank's Richard Koo said that the US is now in a "QE trap," a situation in which any signal that it will taper sends rates soaring so much that they threaten too much damage to actually taper.
In other words the QE trap is that the Fed won't taper until the economic growth becomes self-sustaining, but a taper announcement may prevent that very thing from happening.
In other words, neither Koo nor anyone else seems to know how the US will manage a QE taper that doesn't cause risk so much damage that the US needs, well, another dose of QE.
No safe way out?
This past week he was reported saying that after meeting with clients and US officials, he had yet to find anyone who could refute his "QE Trap" theory, thus adding to the consensus that QE has returned from the dead and will likely be around for at least the coming year.
See here for details.
Ramifications Of Another Year Or More QE
Pressures USD as QE seen as potentially inflationary
As usual, that sent the EUR soaring. As we've discussed repeatedly, for example here, (and in depth in Chapter 9 of our book) the EUR and USD virtually force each other to move in opposite directions While that may be ok for Germany, continued EUR strength is a problem for virtually all of the rest of the EU, particularly the weaker GIIPS group. Even France renewed calls for a weaker EUR this week, just as it had back in February when the EUR was at similar levels.
Gold up on its currency hedge value (aided by significant central bank buying by China and others).
US and global equities get a huge boost of support. $85 bln or more will continue to flow from the fed, first into banks, then ultimately into assorted financial markets (ok, into a few loans too). Yields will remain down, so as that big cohort of baby-boomers edges a year closer to retirement age and the need for a steady stream of passive income to fund it, the search for yield will push them into equities. Indeed, a combination of widespread poor financial planning and years of low rates have many so desperately under-funded for retirement that they 37% of middle class Americans don't believe they'll be able to retire. That means they'll be even more tempted to trade risk for yield as they struggle to squeeze more income out of inadequate savings.
Given the continued pressure on the USD from a newly extended period of QE, as well as long term inflation risks, the US dollars decades-long downtrend against most major currencies and hard assets (detailed here). This is no huge surprise, because long term currency trends are uniquely persistent compared to those of other assets like equities or commodities. That's because it's much harder to reverse the economic fundamentals of an entire country than it is for a company, or for the supply/demand outlook for most commodities.
ECB Bank Stress Tests Stressing Markets: A Story To Watch - Carefully
The return of QE for the foreseeable future is the biggest lesson, but this one may be just as big.
Remember, we noted in our 2013 forecast that for 2013 to pass without a crisis, QE needed to work, and the EU needed to avoid another contagion scare. The coming ECB bank stress tests may force that issue.
On Wednesday the ECB announced it will begin a year-long evaluation and stress testing of EZ banks starting in November 2013 -i.e. now. This was arguably the prime reason all the regions closed lower, and was without doubt the news with the most long term significance, as nothing else that day, or this week, carries the potential dangers.
We'll cover this topic more deeply in a coming post, but here are the key things to know now, without getting into the complex technicalities of as yet unclear, and under-funded, rescue mechanisms.
This one is expected to be serious: Unlike prior stress tests, which gave passing grades to Irish and Spanish banks that soon needed bailouts, this one will be much tougher because it's being run by the ECB, which will be henceforth held responsible for EU banking at some point in 2015, so this will be its last chance to avoid unearth the dead bodies and avoid blame for them.
In other words, it's the largest CYA (cover your "assets") operation ever in the EU banking, covering ~85% of EZ bank assets.
So the ECB needs to make sure all the liabilities are exposed and covered before it gets stuck with having them.
That means the EU will be forced to make decisions it may not be capable of making, and that will mean the end of the EU. For example:
The EU Must Recognize Not All Sovereign Debt Is Risk Free: Thus far any sovereign debt held in banks has been considered risk free for purposes of stress tests. Yes, that means, GIIPS bonds too. It's a complete fiction, as the market rates for those bonds show, but ending it has a variety of expensive consequences the GIIPS don't want. For example, many EU banks will find they need to write down assets and replace the lost capital that they don't currently have.
Therefore the EU Must Have Backstops For Failed Banks In Place: Serious stress tests are expected to reveal serious numbers of bad banks and assets, and expose the known but unspoken truth that there are significant sums of bad loans that someone is going to have to eat.
Therefore The EU Must Decide Who Gets Stuck With The Bill: The big question is who, and it's a question that has been dodged since the start of the EU sovereign debt and banking crisis because any solution will be unpopular with two groups that EU leaders and banks can't afford to alienate -
- The voters, or taxpayers, who keep the politicians in office
- The investors that the banks depend on for funding: be they depositors (can't afford bank runs) shareholders (can't afford stock crash) or bondholders (can't afford soaring borrowing costs or defaults from suddenly worthless bonds)
In other words, the EU will have to make decisions about who pays for someone else's mistakes/theft/corruption, etc. It's unclear if there is the political will for that. If not, no unified banking supervision, no assurance that EU banks are investable, no EU crisis solution. We go back to waiting for the next crisis.
That's because if markets believe (or even suspect) that a sovereign nation will need PSI (private or sector involvement), no one will lend to it or its banks, depositors will flee while they can, etc. The mere suspicion of PSI will be enough to force a crisis.
Already, the one most likely to bear the biggest burden, Germany, is getting nervous. Mere weeks ago it hardened its stance against granting direct access to euro-zone rescue funds (Germany is the biggest contributor) for troubled banks. It insisted that losses be imposed on bondholders before any taxpayer money comes into play, making it harder to set in place a common safety net for lenders.
In sum, the ECB knows it must have a credible, funded backstop in place, but the politicians have yet to decide who bears what portion of the cost. Per a Morgan Stanley survey, that cost is currently (read: going up!) estimated to be around 50 bln EUR ($69 bln).
European Earnings Providing Limited Support For Stocks
Per Thomson Reuters StarMine data, 27% of the STOXX Europe 600 have announced results, of which 57% have met or beaten predictions, down from 62% in Q3 2012.
Per a Barclays note this week, earnings estimates for the European STOXX 600 index were falling at an accelerating rate, with aggregate downgrades rising from 26 basis points to 52 basis points in the last week.
China: Credit Crunch Scare
There were also some important lessons about market movers coming from China.
Fears That Tightening China Credit Threatens Chinese, And Global Economies
On Tuesday, while other Asian stock indexes were flat, and Western Indexes were overall strongly higher, China's two big indexes in Hong Kong and Shanghai were down hard around 1% as benchmark interbank lending rates continued higher, signaling possible tighter credit conditions that would limit growth.
We saw a similar situation earlier this year, which ended with China soon easing conditions and lowering rates. The consensus explanation was that authorities wanted to send a message to Chinese banks to do one or both of the following:
- Improve lending standards in order to prevent a future wave of loan write downs
- To increase loan loss provisions so that the banks would be prepared for such losses
It appears they failed at #1 but succeeded at #2.
Rising Default Rates Rock Markets Wednesday
Wednesday, China's growth problems hit all global risk asset markets, as shown by virtually all leading global indexes down in all three trading sessions, Asian, European and US, breaking a 6 session winning streak for the S&P 500, our preferred global stock and risk appetite bellwether, for reasons covered here.
Bloomberg reported a tripling of loan loss write offs at 5 of China's largest banks:
Industrial & Commercial Bank of China Ltd., the world's most profitable lender, and its four largest rivals expunged in the first six months 22.1 billion yuan ($3.65 billion) of debt that couldn't be collected, up from 7.65 billion yuan a year earlier, filings showed," according to the report. "That didn't pare first-half profits, which climbed to a record $76 billion, as provisions were set aside in earlier periods when the loans began souring.
As noted in our weekly summary of daily market movers above, there were other factors, but this one was as big or bigger than the others, as it was the only truly new news of the day. Lessons include:
- Markets Remain Worried About A China: The spike in loan write downs clearly aggravated China slowdown fears, and news that does that WILL be market moving. In particular, markets appear to see this as a warning of further losses to come. Maybe, after all, China is known for 'managing' its information carefully. While it's no longer socialist, it's still a dictatorship without a free press. This lack of transparency is well known and feeds market tendencies to flee at any sign of trouble, because investors don't expect bad news to come out until it's too late.
- The other lesson is that in fact the loan loss news was significant purely for its sparking a selloff (at least in Asia) rather than for any actual indication of brewing banking sector trouble. As Marc Chandler argued, this was ultimately a positive development in solving a problem that everyone already knew existed - a pile of bad loans lurking in the banking system that needed to be written off. Drawing on loan loss provisions is part of the banking business. Provisions had been made, profits unaffected, end of story. He concluded that the dive in Asian stocks (European and US indexes were only down modestly) was simply a technical correction as weak hands who had recently entered the market got scared by the news and closed their long positions.
Deutche Bank: China Key Consumer For Western Manufacturing, Could Drive US Capex Boom
While it's no secret that China is the world's single biggest growth engine, we saw this week that one reason for so much market sensitivity to China economic data is that China is such a key CONSUMER of manufactured goods.
Although we think of China as the world's biggest manufacturing exporter, many miss the fact that US and other Western manufacturers are sensitive to demand from China as their key customer. As Deutche Bank's David Bianco (via businessinsider.com) shows in the four charts below, the U.S. manufacturing sector is more sensitive to demand from China than it is to America's booming housing and auto industries.
6 Lessons For The Coming Week: How Fed, ECB, POBC Ruling Markets
03 oct 25 1551
"Even as housing starts and auto sales were ramping up, manufacturing slowed and came to a standstill," said Bianco. "This can be explained by slowing in China. China's demand for capital goods should accelerate as urban living standards improve."
China's capex boom has long been key to Bianco's bullish U.S. stock market outlook, because he believes that
"Strong investment spending is what drives S&P 500 sales and non-financial profits…The whole debate about the S&P is about when this turns back up again."
04 oct 25 1601
Bianco believes that the manufacturing boom driven by China's capex spending could "very well reignite capex in the U.S."
Caterpillar (CAT): It Won't, At Least Not For This Year Or Next
However in its Q3 earnings report, Caterpillar, management cut its outlook for 2013, and predicted flat revenues and earnings. A prime reason cited was weakness in demand from China.
The reason we pay special attention to this announcement is that Caterpillar is one of the largest multinational makers and sellers of construction and mining equipment worldwide. Thus it is extremely sensitive to global economic activity. Weak forward guidance from the firm suggests a weak global industrial outlook in general, and in this case, for China.
Bank of America (BAC): Four China Credit Concerns, Market Over Reacting
Last week, Bank of America's Ting Lu addressed four concerns about China's credit tightening:
- Nonperforming loans written off by the five largest banks tripled
- A repeat of the June-July liquidity worries as interbank rates rise
- Reports that a central government official announced policy tightening
- Central government pressuring local governments to set 2014 target based on realistic targets
He concluded that for each of these markets were over-reacting and that they weren't as bearish as market reactions suggested. See here for details.
US Home Sales: As Investors, Not Owners, Support Housing Market - A Troubling Sign
Remember that a classic signal that the US housing bubble was unsustainable was the dominating presence of investors rather than owners who could afford the home and its mortgage payments. In other words, prices were not sustained by actual demand from qualified owners but from speculators hoping to sell for a quick profit in a few years. As supply of buyers, credit worthy or not, exhausted, investors fled, prices fell, and the unqualified buyers defaulted as their homes were now not worth the cost of the mortgage
The bright side is that 33% of those buyers are cash buyers, so no immediate mortgage default risk. However if prices and rents fall due to oversupply of rental units, those investors could flee, driving down home prices and encouraging defaults from buyers who did use borrowed funds but don't want to pay on homes no longer worth the cost of the mortgage.
Q3 Earnings Mattered Somewhat, Influence Likely To Fade
For all the attention they got, earnings played a secondary role last week. It was the third week of earnings season, after which point the tone is usually set. They've been overshadowed by the above market movers. With QE back firmly in place and no EU crisis, markets have managed just fine, thanks.
Disclosure/disclaimer: No positions. The above is for informational purposes only. All trade decisions are solely the responsibility of the reader.