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Erwan Mahe
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Erwan Mahe is an asset allocation and options strategies adviser for the largest European Asset Management firms. Publishing macro-economic research, he has been managing leading European financial brokers since 1987, and sold his company, Paresco Futures, to the OTCexgroup in 2005. He is now... More
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  • Microman vs Macroman ! 1 comment
    Jul 16, 2010 1:11 PM | about stocks: TLT, SPY
    This headline, which may appear to come straight out of a bad manga, perfectly reflects the apparent contradiction in the latest Thaler's Corners between our tactical short-term biases, entailing a positive stance on risky assets and negative stance on the Bund, and our long-term macro biases for a number of weeks now.
    A certain number of clients have asked me how I am coping with this apparent case of schizophrenia, given they too have experienced this same disagreeable feeling.
    I would thus like to take advantage of this "extraordinary" moment, as markets are ignore bad macroeconomic news to focus on the good micro news, to clarify a point about the construction of our scenario.
    Let's being with in the United States:
    ·        The Purchasing Index (Mortgage Bankers Association) has just reported a decline of 3.1% for the week of 9 July, bringing this index to its lowest point since …1996! Given the financing rates are historically very low (4.70% on 30-year loans) and that prices have plunged between 25% and 30% from their peaks of three years ago, this does not augur well for the US real estate market in the months ahead.
    ·        The predictive indicator ECRI (at least, more predictive than the ISM) of the Economic Cycle Research Institute continues to decline, -8.30. It has been in negative territory since the end of May, from +28.40 in Mid-October 2009! As Mr Rosenberg has clearly stated many times (‘Double Dip, Anyone ?’), this phenomenon shows that we have hardly exited from the Great Recession.
    ·                    The contraction in Commercial and Industrial Loans (C&IL) started again. Both the decline from high point (-25%) and its pace (-17%/year) have been the greatest since the Second World War.
    ·       Further as to credit and velocity, the Death of Securitisation’ is as relevant as ever. Outstanding Asset-Backed Commercial Paper volume, despite its recent stabilisation at around $400bn to $430bn, remains 35% below that of the last recession of 2001-2002 and, especially, now represents just a third of the $1.22 trillion of July 2007!
    ·        On the unemployment front, the first impression of improvement, following the latest publication (9.5%), must be weighed against the fact that the percentage of the population employed has fallen again, to 58.5%, to the lowest level since … 1983! (graph St Louis Fed). As for American SMBs, about which Bernanke has expressed concern, consider their position vis-à-vis employment(NFIB):
    Over the next three months, eight percent plan to reduce employment (up one point), and 10 percent plan to create new jobs (down four points), yielding a seasonally adjusted net one percent of owners planning to create new jobs, unchanged from the May reading and positive for the second time in 20 months. Since the third quarter of 2009, job creation plans have underperformed the recoveries from the other two deep recessions covered by the NFIB survey.”
    ·        Retail sales, the American economy's growth motor, declined in June for the second consecutive month and, if we exclude the iPad and IPhone4 effect, here is what the NFIB has to say:
    “The net percent of all owners (seasonally adjusted) reporting higher nominal sales in the past three months lost four points, falling to a net negative 15 percent, 19 points better than June 2009, but still far more firms reporting negative sales trends quarter to quarter than positive. The net percent of owners expecting real sales gains lost 10 points, falling to a net negative five percent of all owners.
    Small business owners continued to liquidate inventories and weak sales trends gave little reason to order new stock. A net negative 21 percent of all owners reported gains in inventories (seasonally adjusted), one point worse than May. Inventories had been built in the expansion to satisfy the spending of a consumer that was saving virtually nothing. Plans to add to inventories declined five points to net negative three percent of all firms.
    A net negative six percent expect business conditions to improve over the next six months, down 14 points from May. Owners do not trust the economic policies in place or proposed and are distressed by global and national developments that make the future more uncertain.
    Check out page 10 of the NFIB report relating the change in sales prices, both expected and actual, which show just how much the current deflation trend, excluding Apple which has the luxury of setting its prices without fear of competition, has become brutal.
    ·        Considering that the Bush administration's tax decreases will come to and end in six months, which amounts to one of the highest tax hikes since the Great Depression (Tax Hikes and the 2011 Economic CollapseArthur Laffer), and the states and local governments cutting budgets to the bone, the macroeconomic situation in the US does not look all that bright.
    In Europe, it is hardly better.
    It is worth noting that our German and Dutch neighbours continue to play their role as deflationary black holes on the Eurozone, much like China plays on the world scene, with their respective publications of +0.8% and +0.2% annual, bringing the two countries ever closer to the danger zone.
    But, "don't worry, be happy", because Mr Stark guarantees us that there is no deflation risk on the eurozone. And, following his campaign to hike ECB interest rates in July 2008, we all know how seriously he takes his roles as Chief Economist at the ECB.
    As for European Central Bank, look at the surprises we had today:
    ·        Mr Mersch declared this morning in an interview with the WSJ:
    ’We totally rule out any double dip or renewed recession
    I must give him credit for audacity, given that Europe is now confronted with the obstacle of fiscal austerity plans required by the ‘Austrian Ostriches’.
    "I look at [the bond-buying facility] more like a pharmacy. You have one small cupboard where you know it exists and which is closed with a double key and there is a skull on it; but it exists. I think we should not get addicted.
    I guess he is not overly worried; given the €1bn of government bond purchases last week, our paragon of monetary virtue has just established a new record of inaction. At this rate, it will only take 125 years for the ECB to reach the volumeof QE managed by the Fed.
    ·        Mr Draghi seemed to throw a Weberite tantrum before the Italian Bankers Association this morning:
    "No alternative but to withdraw monetary expansion - Must accelerate balancing of public budgets - Budget cutting will be positive if it narrows spreads - EMU monetary policy remains strongly expansive."
    ·        The July ECB bulletin published today:
    Long-Term consolidation gains far exceed short-term pain Must unwind labor support measures in a timely manner.
    ‘Measures should ensure a wage bargaining process that allows wages to adjust flexibly to the unemployment situation and losses in competitiveness.
    ‘A timely dismantling of employment-protection programs established during the crisis is necessary to allow labor markets and economies to undergo necessary restructuring.’
    Yes, that's right: While the only efficient measure taken by Germany, the Netherlands and Austria to fight this Great Financial Crisis has been the Kurzarbeit, since it prevented a surge in unemployment and the celebrated problem of hysteresis, the ECB is now demanding its end!
    Given the ECB's approach on the matter, I can only warn for the umpteenth time against the danger of the Eurozone falling into a Japanese-style lost decade(s).
    It is interesting to note that this injunction in favour of wage deflationseems to apply only to others.
    Just consider that the ECB has openly challenged the Hungarian government's plan to lower the salaries of the country's central bank officials! By the way, the current central bank president, Peter Szijjarto, arns over twice as much as BenBernanke.
    Sometimes truth is stranger than fiction:    ‘Hungary defies ECB on cenbanker pay
    In this global G5 context, our continuously negative bias on risky assets and positive bias on government fixed rate debt, as expressed in these lines since June 2007 (implosion of the Bear Stearns hedge funds and the ‘Death of Securitisation’), stands firm.
    Some may ask: if everything is so macro-clear, why did I move to a positive short-term bias on risky assets and negative bias on the Bund on the10 June? (Thaler's Corner 10-06-10: Imaginary real rates and Animal Spirits!).
    The answer lies with "Microman", who benefits from the current macroeconomic turmoil.
    This super hero, which I use here to designate the earnings. In the framework of purchasable assets, that means the equities of the world's biggest corporations, which makes up the S&P and EuroStoxx50 indices.
    The gloomy macro portrait, described above, does not prevent us to draw radically different conclusion in the short term:
    ·        The Credit problems of SMBs and consumers do not apply to these multinationals, who are increasingly cash rich.And should they need financing,in order to buy their smaller rivals,they are in a position of strength vis-à-vis banks.
    ·        Given their scale as multinationals, they can take advantage of new surge in consumption in emerging countries. Like in the case of BMW whose domestic auto market is collapsing (end of cash for clunkers plan), but which has trouble coping with exploding orders from BRIC.
    ·        Whether they be in the retail, auto or technology sectors, these firms have long been used to work in deflationary environments. As such, they swiftly responded to the Great Recession, by deep cost cuts from the beginning.
    ·        We thus consider the earnings season, which has just begun, was an excellent time to bet on a 10% rebound (2900) on the EuroStoxx50. Especially since the jitters about European sovereign debt and a double dip recessionhave become so consensual since late June that I couldn't help but express my contrarian bias, as irksome as it may be.
    But above all, it is the really horrible macro-economic budget situation that leads me to advise this tactical approach!
    I will not burden you again with the process of this equation:
    After-tax corporate profits =  Consumption driven by capital + Investments  + Budget Deficit
    + Trade Surplus – Employee savings.
    As explained in this year's first Thaler's Corner (06-01-10: Back to school basics), still available on demand via email, this equation is simply the result of the dual-entry national accounting principle.
    Now let's take the example of the United States, which is not all that different from that of the eurozone or Japan.
    ·        Consumption driven by capital revenue: Lacking precise figures on the matter (I am to anyone willing to share them), I have approximate using US Personal Consumption Expenditure (PCE CONC on Bloomberg).
    This variable obviouslycontracted withthe Great Financial Crisis, from $9.3735 trillion in November 2007 to $9.157 trillion in December 2008.
    On an annual basis, this amounts to a 2.10%drawdown, which is colossal for an economy like that of the United States, where consumption grew at an average annual rate of 3.6% from 1995 to 2007.
    But this consumption has rebounded sharply  since the beginning of 2009, and has even surpassed the previous 2007 high of $9.425 trillion in May 2010!
    àThis has thus been a positive factors in the past 18 months for after-tax business profits.
    ·        Investments: Here I use US Gross Private Domestic Investment (GDPITOTC) for which the latest figures are also positive.
    Following an initial plunge from $2.261 trillion in June 2006 to $1.456 trillion in June 2009 (-35% !), these investments also picked up and totalled $1.683 trillion at the end of Q1 2010. They still have some way to go, but Q2 figures are expected to be even better.
    à This has also been a positive factor in the past year for after-tax business profits.
    ·        Trade Surplus: In the United States, we usuallyspeak of negative contribution in this case, because the balance of trade has been almost structurally in deficit since 1982. But its dynamic, which is what interests us in our examination of changes in corporate profits, has strongly improved in recent years.
    This trade deficit (GDPTNET) had grown at a42% annual pace (!) since 1992 to peak at an annual rate of $756bn in Q2 2006. Over-consumption and de-industrialisation are known to be the causes of this phenomenon. The 47% appreciation of the dollar (DXY) between 1995 and 2002 and the over 500% surge in oil prices (from $12 to $74 per barrel) from 1998 to 2006 did not help either.
    However, because ofthe 40% depreciation of the greenback from 2002 and 2008, and of the steep dip in consumption in 2007 and 2008, this trade deficit has been cut in half (!) since June 2008 to $365bn yoy in Q1 2010.
    Q2 will surely see deterioration ($450bn? annual), but even that represents a big improvement from the abyss of  2006.
    à This has therefore also been a positive factor in the past four years for after-tax business profits. It will be slightly less so now, but given its correlation with the pick-up in consumption
    ·        Employee savings: As expressed by the employee savings rate (PIDSDPS), savings initially surged with the GFC, when it climbed from its historic low of 0.80% in April 2008 to 6.4% in May 2009, thus validating the deleveraging process of US households and a overall rebalancing that the world perhaps imprudently seemed to desire.
    However, since then, it has stabilised at around 4%, which is still well below the levels of the XXth century. It averaged 8.5% from 1959 to 1992, at which point it began its downward slide. It was not by coincidence that this coincided with the explosive growth in the trade deficit.
    à Its decline in the past year has thus also been a positive factor for after-tax business profits.
    ·         Budget deficit:  last but not least !
    This is the most important point of my argument for a positive tactical stance on stock markets as of late, because the explosive growth of these deficits should make themselves felt as of now on corporate earnings.
    Given the austerity budgets announced in recent months and deflationary risk, I am not changing my long-term macro biases, despite all the positive points mentioned above, but consider the short-term situation:
    Budget deficits are one of the variables of this equation which has really exploded in the past three years. They averaged $135bn between 1974 and 2007, including a period of surpluses, which averaged $140bn from 1998 to 2001.
    But from the $160bn deficit in 2007, it surged to $454bn in 2008 and then to $1.415 trillion in 2009.
    That makes for some impact on our equation! The US government estimate is for a $1.17 trillion deficit in 2010, followed by $533bn in 2011.
    à As you know both the value of government promises on this matter and that the deficit already hit $616bn at 30 Junethe positive impact for after-profit business profits will remain substantial.
    That will be enough for today: It has been a long time since I have worked on a text in which each paragraph would merit an entire letter.
    Sorry for the length and the density of today's note, but I would hate for you to think that I was going to limit myself to a few lines, as I did earlier this week. When you enjoy what you are doing, the time flies.
    I will return another day on the reasons I do not convert this puff of optimism into something more durable, if some of you take the risk of opening my emails once more.
    Have a good evening.
    Asset allocation biases and advised option strategies
    ·        The long-term macro biases remain downward on eurozone government yields and negative on risky assets (equities, European real estate, commodities) and a deflation/depression scenario, which will require much more effort by the ECB than a shame-faced QE.
    ·        Our short-term biases: a tactical rebound of about 10% on Eurostoxx indices (2900?), accompanied by a narrowing of sovereign debt spreads, resulting in a 2-point decline on the Bund (127-126.50).

    Disclosure: Long 20 years OAT and 30 years BTP Zero Coupons, EDF Corp 5 Years 4.5%, Grece 2 Y and 10 Y bonds, Long Eurostoxx50 ETF
    Stocks: TLT, SPY
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  • XTigerX
    , contributor
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    Whether they be in the retail, auto or technology sectors, these firms have long been used to work in deflationary environments.


    Thank you for that insight. I've been mulling that over for awhile now without being able to bring it into focus.
    16 Jul 2010, 08:21 PM Reply Like
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