Recap 2015-06-03: My Take from Here

Commentary:

The big question remains: when and at what level will US growth pick up?

A few weeks ago, I noted that the amount the US economic data has disappointed vs expectations was unusually wide, and that the dichotomy would begin to converge soon. So far, (as is usually the case) it’s been expectations that have moved. 2Q growth expectations has already dropped sharply, to 2.65% from 3.1%. Given that the 8 quarter average is 2.5%, expectations are probably no longer overly optimistic.

With the benefit of hindsight, it appears reasonably clear now that the strong bounce that many expected following the weak Q1 will not be materializing, as consumers save, rather than spend, their ‘oil tax cut.’ All else equal, this should delay the Fed’s hiking schedule somewhat, though the Fed will likely hold off on signaling as such until the data is more conclusive. We’ve only seen data for the first half of 2Q, after all. Having said that, note that the US economic data surprise index has already begun to turn up, though from very low levels.

As the immediate effects of the oil and dollar move on earnings fade over time, we are likely to see better earnings expectations as well. Citi notes that 9 out of 10 S&P 500 sectors showing EPS revisions to the upside thus far in May. To me, this is probably a more timely indicator for when the Fed goes. Earnings, after all, provide the room for additional hiring and spending. Another way to put this is that not only is S&P momentum likely to pick up in the next month or two, such a pickup is probably a prerequisite for Fed hikes.

Note that that the data surprise and equity sentiment seasonality bear some similarity to last year. Historically, US data weakness has tended to last around two quarters and trough around late 2Q. This year we may see a repeat of that:

The seasonal trough also seems to apply to equity sentiment. (Proxied by the AAII Bulls-Bears difference in the chart below)

In fact, note that equity sentiment (proxied by the 9 week moving average of the AAII Bulls-Bears differential) is now roughly at the lows of last year:

Given all that, it shouldn’t be a surprise if S&P price action roughly follows last year’s pattern as well:

In rates space, EU fixed income remains a major driver. There are clearly a number of trapped longs. (Was it just a couple of months ago that people were projecting 0% yield on Buxl??) But valuation indicators suggest we are nearing ‘neutral’ levels. First, long dated EUR real yields have bounced back sharply from an implausibly low -100bps to just below zero, which was where they were at the height of the EU crisis. While one could make the case that they are still too low, this is no longer an obvious call, given the size of the EU output gap. Moreover, as a precedent, the US 30y real yield also traded around zero from late 2011 through early 2013.

Furthermore, the differential between US and EU 30y yields are now roughly back to the range prevailing in 4Q last year, before the hysteria around the ECB QE became feverish:

I’ve long held the view that the fair level for US 30y yields is roughly 3%. With yields not far from there, there isn’t much value in a significant position here from my point of view.

Having said that, it will certainly take time and additional volatility for the market to find the appropriate clearing level for EUR yields. This is very likely to add vol to EURUSD. This, in turn, is likely to add volatility to all USD crosses. That would be mitigated if other central banks eased further, but the appetite for that appears quite low at this juncture. For example, additional easing by the BoJ seems unlikely. The risk/reward trade off for them at these levels of asset prices is poor, as is the political appetite. While the BoJ continues to desire a weaker Yen over the long run, they will depend on Fed hikes to cheapen the currency further, and seem happy to sit on their hands in the interim. This is the playbook for other CB’s this year, such as the RBA. That is another reason the USD may be range bound until the Fed begins to hike. As a result, I don’t think it will be a fun summer, or even a fun autumn for USD bulls, even as they will be proven right over the longer run.

Other Thoughts:

  • EU earnings expectations are improving at the fastest rate since 2010. That has helped mitigate the negative impact of the move in yields.
  • MIB (Italian equities) are unusually rich here and likely to underperform its peers.
  • Long dated USD IG credit spreads look unusually wide and hence interesting
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