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March 9, 2013

There are no facts, only interpretations Friedrich Nietzsche

Februarys economic notables

| Rodrigo C. Serrano, CFA | SIPA | Columbia University Master of International Affairs 14 Candidate | New York City, NY | 01-305-510-0181 | rcs2164@columbia.edu !

Despite metastasizing regression in macroeconomic data within the major locomotives of the global economy, major U.S. and global equity indices have maintained a resilient bullish trend throughout the past month. Nietzsches conception of Apollonian and Dionysian dichotomy; which symbolizes the forces of logic, reason, and individuality inherent in Apollo, versus those of chaos, euphoria, and loss of originality, epitomized by Dionysus, is an ever-present element in financial markets. A shrewd investor possesses the ability to personify one or the other at opportune times. Disappointing economic metrics have been interpreted as transitory and largely benign in the grand scheme. The global recovery continues and will be led by developed economies such as the U.S. and Europe. The bullish analysis dominates. Investor sentiment suggests that investors have espoused Dionysus. Is it time to embrace Apollo?

Investors are interpreting worsening economic data in major economies as transitory and manageable. Upcoming months will be key in discerning the genuine trend. The bullish disposition: In U.S., strong internals reside within weak service and manufacturing data. Job market continues healing. Consolidating recovery forges on in Europe. The bearish set up: French divergence is cause for worry. Unemployment remains high and rising throughout periphery. In the U.S., the consumer picture remains clouded with a bearish hue. Housing market slowing. External demand fleeting for China. Regressing economic data along with first domestic bond default since 1997 merits anxiety. Increasingly cautious: Still positioned slightly bullish; but making contingency plans. Largest near-term risk now China.

Highlights

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In the U.S., the bullish disposition has faulted Mother Nature for transitory, sluggish business performance. The U.S. service sector, which accounts for roughly 68% of economic activity, grew at its slowest pace in four years in February, according to the Institute of Supply Management (ISM). This deceleration was also evident in Markits sister report. Meanwhile on the manufacturing front, the ISM noted a lackluster rebound to 53.2, after Januarys significant decline from 56.5 to 51.3. Taken together, these metrics imply a faltering recovery. However, investors have rightly focused on the internals of these reports. Despite the alarming headline number, backlogs and new orders within the ISMs service sector poll suggest underlying mettle (see chart on next page). Markits study confirms this corresponding sturdiness. Concurrently, behind the bearish headline number in the ISMs manufacturing inquiry, member commentary was peppered with references of inclement weather affecting business. To add, both new orders and backlogs strengthened. Even better, Markits sister report, the Purchasing Managers Index (PMI), rose to a 4-year high and was accompanied by strengthening new orders and backlogs as well. These noteworthy results are occurring alongside a strengthening job market. Lower jobless claims, an overall constructive payrolls report, and expanding hiring plans in the NFIB small business optimism index more than offset the ISMs service sector survey employment sub-index, which fell into contraction territory for the first time in more than 2 years. The current conditions sub-index within the Conference Boards consumer confidence report reinforces better conditions on Main Street. In Europe, rising stock indices suggest a consolidating recovery. Overall the data have supported this position. Investor confidence in the Eurozone recovery is the highest in more than 2.5 years, according to Sentix. The region-wide optimism begins in Germany, where the Ifos business and GfKs consumer climate surveys notched new highs; the latter registering its best result in 7 years. Markit reported multi-year highs in either service or manufacturing PMIs in Germany, Spain, and Italy. Furthermore, the organization revealed that its Eurozone composite PMI increased to levels consistent with an economy growing at a 0.4-0.5% clip (see figure on next page). This would translate to an annualized growth rate of 1.6-2.0%, much quicker than current market expectations. Pessimists pointed out that past bullish surveys were unconfirmed by hard data. This has begun to change. Euro-wide retail sales rebounded strongly, putting to rest bearish remarks of a collapse in consumer demand. A stabilizing region-wide CPI means demand is slowly returning. Meanwhile, Greek YoY industrial production expanded for the first time in 6 months, while Germanys metric grew at a pace last seen in late 2011. Factory orders rose by the most in 2.5 years in both Germany and Spain. These bullish data points follow robust and broadening Q4 GDP figures. Europes recovery continues and will provide a tailwind for global growth

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However, ecstasy has failed to capture those who worry of Frances diverging economic trajectory and solidifying asymmetries, which are inherent in a flawed fixed-currency region. In France, household consumption tumbled 2.1% in January, while Markits service PMI sank to a 9-month low last month. While inflation seems to have stabilized region-wide, closer inspection finds France creeping towards deflation as conditions sour. Meanwhile Italy and Greece reported fresh record highs in unemployment, 12.9% and 28% respectively; youth unemployment is now an infamous 42.4% and 61.4%. The infirmed state of growth can also be seen within the aforementioned bullish German factory orders. Improvement was led by domestic demand. Foreign orders by non-eurozone members gained 7.2%, while orders from members within the currency bloc decreased 8.8%. In the U.S., the housing market continues to slow. While most have attributed this weakness to the weather, closer scrutiny suggests demand slowed as mortgage rates increased mid last year. Slowing conditions have given investors cold feet. Cash deals, which constitute a notable share of purchases, declined year-end. Still relatively high mortgage rates and continued double-digit YoY falls in MBA purchase applications suggest more disappointment for new and existing home sales reports in the months ahead, as well as prolonged contraction in the NAHB housing index. Stagnant growth in permits and starts may be a harbinger of reduced construction activity. The next couple of months will be key for the housing market. Meanwhile, the consumer picture remains precarious. Despite constructive jobs reports, consumer confidence has stalled over the past 6 months. Simultaneously, the YoY growth rate of core retail sales is now at a level that prevailed throughout the beginning of the Great Recession. Over Nov., Dec., and Jan., growth contracted at a 0.23% annualized rate. Whats more, car sales have disappointed in 5 of the past 6 months, a streak that began well before the nasty weather. In fact, 50% of the downward revision in Q4 GDP (from 3.2 to 2.4%) was due to weaker spending on consumer goods. Couple this with the fact that close to 50% of real economic activity in the second half of 2013 was a result of accumulating inventories. The result, anxious retailers watching their inventory-to-sales ratios creep higher. The current dominant bullish interpretation of released pent-up demand in the spring is audacious when considering that gas prices are at their highest levels in roughly 5 months.
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Chart: RCS Investments

Internals show meddle

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Chart: RCS Investments

Cyclical upswing ongoing

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In my outlook at the turn of the year, I pointed out that China needed external demand to! carry out its reforms. Reported this past weekend, a plunge in January exports (-18.1%) by the most since the financial crisis has dealt a critical blow to bullish hopes. This result may change the benign perception of the yuans recent weakening. The trade number accompanies a 7-month low in the HSBC manufacturing PMI (48.5) and an 8-month low in the governments measure (50.2). Explications from an overcrowded bullish cohort that Chinese leadership will succeed in taming the nations credit growth and restructure the economy, while external demand provides stability, are on thinning ice. The surprise could be a significant policy reversal as authorities desperately attempt to avert deteriorating economic data. We may be already seeing this when surveying Januarys record increase in Aggregate Financing data, the broadest measure of credit, and no change to the M2 growth target (13%) from last year. However, this growth model is proving increasingly unsustainable. Total corporate debt stands near 150% of GDP, according to Credit Agricole. Shadowbanking accounts for roughly 63% of GDP. News of Chaori Solar Energys default a couple of days ago, the first since the PBoC began regulating the domestic bond market in 1997, combined with deteriorating economic data, should increase anxiety over the short term.

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Ensconced asymmetries
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I am concerned with developments out of China. The damaging export number may forewarn of reduced import demand (copper has collapsed as of late). January export growth of 20% in Australia (fastest in 3 years), while certainly bullish, may prove fleeting. Europe, however, remains on the mend, but parliamentary elections means political risk looms. Will recent improvement translate at the ballot box? I expect a bounce back in U.S. economic data (service sector) and continued healing of the labor market. However, I remain vigilant on developments on the U.S. consumer front. My portfolio remains tilted towards a slightly bullish posture; however, I am readying a downside protection strategy, should these trends continue. I increasingly seek the wisdom of Apollo.

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