I haven’t written much about the whole Greek saga because I didn’t think I had anything new to add to what I had said before and what was being reported elsewhere. But now it appears that the general perception of the process is vindictiveness by Germany. Now, perhaps this is right, but that is also short sighted. The fact is that with the expiry of the previous deal, the parliaments of the other EU countries would have to approve new packages. The representatives of many EU countries will have a hard time selling anything except a more draconian package to their constituents, especially given all the good will that the Tsiparis government has burned up over the past few months. This is not a major mistake by Merkel. This is the reality of the politics and laws of the EU, driven by all the foibles of democratic constructs. The fact that the fiscal transfers require the buy in of all EU countries is equivalent to requiring that the US pass all budget bills with a majority in every state house.
Moving on, from a high level macroeconomic perspective, the broad themes continue to drive longer term trends.
- US Growth remains decent. But the recent drop in oil prices may give the Fed a bit more room to hold off.
- EU Growth likely to continue picking up. The recent Greek saga has been too short to have had a major effect on the data released so far
- Chinese Growth looks likely to continue to slow for at least another 6 months. The stock market there remains overvalued, IMHO, but the economic ramifications seem limited. In the short run, all the trading is really just a shuffling around of paper wealth from one group of constituents to another. There does not appear to be any large scale bankruptcies or credit defaults directly related to the bubble, at least not yet.
With respect to asset prices:
- US yields look near a top. Same for EUR yields. I noted a while ago that valuation wise they look pretty fair, but now price action supports that view. In both areas, yields were not able to sustain new highs despite the equity market rallies.
- Credit spreads are quite wide relative to where we are in the economic cycle. By some measures, they are implying nearly recessionary level default risks. Perhaps it is related to the fixed income market liquidity fears that may be more acute now that we are nearing the first hike, but it is affecting risk premiums across the capital stack. The widening has driven financial condition readings (as published by several sources) to unusually tight levels. I am willing to bet that this is something the Fed is monitoring reasonably closely.
Barclay’s had a couple interesting charts on this, noting that investment grade issuance is up 15% vs where we were last year:
- I have been sanguine on EU equities in the 1H of this year, as they were plagued by duration exposure since the ECB’s QE announcement. But the improvement in the data and in earnings since then, along with the stabilization of yields and the recent position washout means that all the pieces are now in place for a decent rally. My models suggest 1y fwd EPS estimates are likely to pickup up ~10% by year end (non annualized) from here.
- Equities in aggregate look set for a strong 2H given investor positioning. The BAML Fund Manager Survey shows the highest cash balance since Lehman, and before that Nov 2001:
- EURUSD downside is probably limited. At this point, I think relative policy rate differentials are broadly priced in here.
- AUDUSD is very overvalued, and the impetus for further downside look very attractive. Despite the employment data recently, the broader economic backdrop both there as well as in China will require a further adjustment in the currency. I expect a depreciation in excess of 20% over the next couple years.