While conflicting market signals continue to cloud the macro picture, we do feel that the recent data goes some way towards undermining the case for a “double dip”.
Conflicting economic indicators, along with market signals that could easily be characterized as schizophrenic, make it tough to take a firm stand on whether the glass right now is really half full or half empty. While Derastone has a long-term positive outlook, we are using this time period only to add risk at the bottom of current ranges, pending a clear indication that trading ranges have been broken. It may be that the price levels of the major asset classes (credit markets, commodities) which appear to be influencing equities, will lead the change in perceived fundamentals.
The positive side continues to be the same, with Emerging Markets [EM] recovery gathering steam and approaching self-sustainability. It is still surprising to many when they hear that Chinese consumers now buy more cell phones, cars and LCD screens than Americans. The response is almost always the same: Isn’t China a bubble? Yes, there is a real estate bubble in China and a nasty financial sector, but beneath it all there is a manufacturing power house that continues to drive the global economic recovery.
China is now the #2 applicant for patents in the world, and can no longer be stereotyped as a nation of sweatshops pumping out cheap clothing and lead painted toys. Furthermore, as an IMF study this week showed, trade routes within EM are increasingly independent of Developed Markets [DM], in contrast to much of the 20th century. During this new stage of globalization we are in, the fastest growing trade links are not DM-EM like in the past, but EM to EM. That makes a world of difference. As O’Neill is able to summarize so well, the jury is still out whether it’s the US financial conditions or the US economy that matters most to EM. In 2008 we had both shocks. This time around, with the world swimming in liquidity, at worst we’ll only have the second. That doesn’t spell doom for EM, it spells a bubble.
We could be in a period where certain high carry EM countries continue to do well for the foreseeable future in an environment where DM muddles along with moderate growth and very low interest rates. With the exception of further economic deterioration in the DM, we are increasingly optimistic that we may be in the embryonic stages of a longer-term relative economic and financial differentiation between DM and EM. The natural progression of this would strengthen the case for EM valuations trading at a premium to developed markets due to better growth rates, more attractive demographics, further deepening and liberalization of capital markets, the emergence of new sectors, and increased weightings within global equity benchmarks. So where does that leave us? Strategically bearish in DM, bullish in EM.
This makes us in par with the broad economic consensus, but tactically, we still can’t get ourselves to be bullish in our actions. Yes, sure, data was good. And yes sure, data could be turning up in the US (Europe I suspect is going to start turning down). But all the other concerns still remain. We've been kvetching since late July that Europe was going to get in trouble once the elite came back from their August chateaus. Two million people went on strike in France this week to protest pension reforms that are needed to prevent PIGIBs from becoming an even longer acronym.
To put the strike into perspective, France has a working age population of 26m people. We believe there is a 50%/50% chance Ireland will be getting an emergency check from the EFSF in less than thirty days. And now the long anticipated break-up of Belgium seems closer as talks between Flemish and Walloons parties have collapsed, and it will probably take months before we reach any sort of outcome. As a reminder, if the Flemish leave Belgium, the Walloons will most likely be forced to go to the IMF. And coming soon: the Spanish ratification of the early summer labor reform that passed by 1 vote.
In Europe, we are not complacent; we think the markets underestimate the political calendar in the next two months and just how hard it’s going to be to pass a decent budget for 2011 in some of these countries (riots in France and indiscreet political leadership in Spain worry me most).
The US election is going to be crucial for the 2011 outlook. Our gut feeling is that there will be no agreement on tax cut extensions before the election and tax cuts will only be retroactively extended in 2011, creating havoc. Finally, there is the increasingly material risk of a US-China showdown. China insists on not allowing its currency to appreciate. We are not sure if it is because they believe that the US congressman and senators are only putting on a show for CSPAN, or because they want to cause a crisis for some other ulterior political motive. In either case, it is clear to me that Hu, Wen & Co. don't get it.
Furthermore, CLSA is spreading a rumor that Obama has sent Larry Summers to Beijing this weekend to ask China to take more seriously the congressional anger over the allegedly lop-sided exchange rate. The democratic leadership of the house is determined to pass Congressman Tim Ryan’s "Currency Reform for Fair Trade Act" before the elections. The senate will be harder to pass, but we feel like it’s even odds there. And if an Anti-China bill hits Obama's desk before the mid-term election, it’d be political suicide to even contemplate vetoing it.
At Derastone, we believe we're clearly still trading in broad ranges, and this will hold for the short to medium term. These issues are too severe and create too much uncertainty for an upwards breakout any time soon.
Disclosure: No Positions