Europe’s domestic resurgence

In the Jefferies note two of their market recommendations for an equity market tilt were in Europe’s two biggest economies, Germany and France. It is interesting to note Germany where retail sales have broken through a 15-year high, and created the unique situation where household growth has improved significantly enough to enable them to save and spend more at the same time. The economics team at Credit Suisse has published this extensive outlook on the European economy, analysing the external, financial and political risks. They explore what’s behind the key driver behind the European recovery, domestic demand and why they expect this to continue.

Active Equity, Passive Currency and Pricing Power

Sean Darby, chief global equity strategist at Jefferies has just published this asset allocation piece, that builds upon a theme we referred to in yesterday’s newsletter, the Global Savings Glut (GSG), which has been a contributor to the narrowing of aggregate international bond yield spreads meaning exchange rates are bearing the brunt of adjustment. Jefferies propose the following investment strategies: Passive bets should be made on exchanges rates rather than indices, active tilts should be made by equity investors based on pricing power between consumers and producers. Their bottom line is that the ongoing tightening in global liquidity and increasing real value of the US dollar ought to mean increased volatility.

The relief rally has largely played out

The relief rally that has been underway since the August 24th intraday lows is largely played out, writes Chris Watling, CEO and chief market strategist at Longview Economics. Adding to Longview’s near term caution towards equities, Watling identifies three rising risks associated with markets at this current juncture; The Fed, EM stress and recent price action (S&P500 continues to make lower lows). Thus they recommend removing their tactical overweight equities position.

Dilma is a lame duck

Medley’s Bernado Wjunski has been a perceptive observer of political and economic developments in Brazil for sometime now and he held a conference call for clients late last week to update them after Brazil’s credit rating downgrade and to discuss whether this will be a turning point for the economy. The key question: Will it spur President Dilma Rousseff and her embattled Finance Minister Joaquim Levy to finally deliver the fiscal adjustment they have been promising. In summary, he does not think it will the turning point and that’s because the political situation is extremely complicated. Dilma’s desire for political survival means she is unlikely to embark on fiscal tightening. It is not about willingness to change anymore. Dilma is a lame duck and is unable to deliver difficult policy choices through an incompatible coalition.

The dogs that didn’t bark in the EM rout

Jonathan Anderson from Emerging Market Advisors provides some excellent perspective on the EM selloff by reminding us that it is often too easy to tar the EM complex with the same brush. Clearly there has been a lot of pain, and the general bearishness is still justified – with China at the epicentre – but looking beyond China the fall out has been more muted. In this piece entitled: ‘’The Dogs That Didn’t Bark Last Month,’’ Anderson illustrates that that there wasn’t any meaningful increase in capital outflows, no stress in local debt or interest rates and a much milder drop in local currency equity markets. This all goes to show that the game has not ‘’changed,’’ or in other words, investors can continue to look for normal signals of external stabilization and potential upturn ahead. In short he says, the culprit is FX, which means investors can have a fairly good idea on what to look for at the bottom.

FOMC: Which decision would be costlier?

Former Fed Vice-Chair Don Kohn, in his capacity as economic strategist for the Washington-based Potomac Research Group, held a call late last week to preview this week’s Fed decision. He reckons it’s a very close call, and that even within the FOMC committee itself there doesn’t appear to be a strong consensus on what the final decision should be. Kohn suggests two possible outcomes: 1.) A rate rise, accompanied by a statement that suggests they will pause till 2016, or 2.) No action, accompanied by a statement confirming an expectation that they continue to think a rate rise will occur in 2015 assuming the economic data comes in as expected. Kohn assesses the likelihood of either of these outcomes from a ‘’risk management’’ perspective, by posing the question: Which decision would be the more costlier mistake? He thinks raising rates would be, and so on balance argues for the Fed to remain on hold this week. Kohn also opines on the potential impact of a government shut down on the Fed’s outlook and the need for the Fed to shift away from data dependence to outlook dependence. This would be more preferable because it takes the data and filters it through their outlook for the future, which separates the signal from the noise and therefore less dependant on individual months.

Quantitative tightening; it’s complicated

Fear mongering that equates Chinese FX reserve sales to an unwinding of central bank QE misses the broader point, writes BCA Research in a recent blog post. In its recently published ‘’Insight’’ publication, BCA showed that there has been no consistent relationship between Chinese flows into US Treasuries and the level of yields for the last 15-years. More important for global bond yields perhaps is the evolution of ex-ante savings and investment flows, which has been driven by the so-called ‘’Global Savings Glut,’’ (GSG), they argue. This phenomenon has begun to re-emerge as a dominant force, especially as fiscal austerity has become more entrenched at a government level. BCA recognises that a key part of the GSG story was China’s fixed exchange rate policy and they understand that the fear that China could potentially abandon this policy. This question will be addressed in their next edition of ‘’Insight’’ they explore this in more depth. If you’re a BCA client keep an eye out for that.

Do equity markets listen to credit markets?

A lot of deleveraging has taken place since the financial crisis of 2008, but this phenomenon is primarily related investment grade credit. As far as high-yield credit is concerned leverage isn’t just high, it’s worse than it was heading into 2008, according to UBS. The bank’s US credit strategist Matthew Mish has been well ahead of the game in pointing out the risks in the US high-yield market as a result of increasing default risks in the energy sector. In his latest piece – co-authored with Stephen Caprio – Mish explores the influence high-yield markets have on equity markets and their influence on relative returns. Their analysis of historical periods shows that when leverage and spreads were elevated there is evidence that high-yield spreads are increasingly likely to lead equities.

Germany’s potential refugee dividend

The influx of refugees into western and northern Europe this week has been a big political and social story. Unicredit’s Chief German economist, Andreas Rees has written a very interesting piece on the economic benefits to Germany of a successful integration of refugees that it has announced it will accept. The German government has revised upward its projection to accept asylum applications up to 800,000 from 200,000 in 2014. Aside from the short-term impact to GDP of increased government spending to accommodate the refugees – which Unicredit estimates will add 0.2% to GDP – the medium term benefits could see GDP lifted by 1.7% by 2020. This is the result of a significant increase in the working age population, but success in achieving will be dependent on how they can be integrated into the labor market. Rees hasn’t just done some ‘back of the envelope’ calculation here, and he backs his analysis with some rigorous academic evidence on the economics benefits of immigration from the likes of Robert Gordon.

A US recession is closer than we think

Charles Gave from GavekalDragonomics doesn’t mince his words in his latest note on the US economy, as he challenges those optimists and forecasters who predict that economy may be on the verge of ‘’achieving take-off velocity.’’ For starters, how can anyone have any confidence in official growth forecasts when they are continually overstated year-after year, he writes. Gave gets down to basics and starts with some economics 101: GDP equals private consumption + government spending + investment + net exports. He addresses each of these variables and sees little optimism in private consumption, government spending and investment, and as for trade (one component that has defied gravity) he explains why this could be ‘’the next shoe to drop,‘’ meaning the US may be closer to recession territory than many economists acknowledge.