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China And Us Claim Economic Gains, But How Much?

Fuseworks Media
Fuseworks Media

Recent news from both the US and China have generally been better. Goldman Sachs global markets says it does not yet see clear enough evidence of stabilizing growth to take a more aggressive pro-risk stance, though we remain on the lookout for those signs.

Our relative view of the US versus the rest of the world - so-called "decoupling" - is still the part of our outlook that is most clearly not priced. We continue to focus on that theme and the relative merits of different ways to trade it, still leaning towards exposure to China and the smaller G10.

But in doing so, we have been a little less strict about staying 'risk-neutral' than we were through August given the better news flow. Like many we talk to, we also focus on QE2, its potential timing and impact, particularly where it reinforces trades we already like.

2. We have argued that risky assets are again likely to respond to signs that the US slowdown is reaching a plateau. Recent US data - payrolls, the ISM, jobless claims, the trade balance - has generally been better and the SPX has outperformed on US "data days" so far this month, reversing the pattern of June/July. Our GLI has also shown more life in some components recently, even as overall momentum has fallen. The fall in claims from recent highs has been particularly intriguing, given that peaks here have often provided reliable confirmation of market troughs. But while the news has been a little better, our own criteria for "stabilisation" have not yet been met. In particular, the composite ISM looks troubling, the new orders-inventories balance in the ISM has continued to fall and our GLI is still falling. Until these things change, it will be harder for us to really back a risk recovery. This week, the Philly Fed (and its inventory/orders balance) and our Advanced GLI will provide key updates and a chance to assess again.

3. While we think it is data that is likely to be the key to whether markets can extend their recent rally, renewed European sovereign issues has added an additional layer of complexity. Thomas Stolper argued for some time that political risks in Europe would come back in the late summer, one key reason why our near-term EUR/$ forecasts have been negative. As Kevin Daly set out last week, our view is that the Irish situation will ultimately prove manageable - alongside a likely more aggressive fiscal adjustment plan. And after the spread widening in August, we recently added longs in Italian versus French 10-year government bonds and outright longs in 30-year Greek bonds, where implied default risk is already high. The road here may be (and already has been) a little bumpy at least for a few weeks more, but so far spillovers to broader assets - even in financials - have been more limited and we do think the overall macro backdrop has been sufficiently better to take on selective risk of this kind again. We were unlucky to be knocked out by a tight stop of a short in September VIX futures a few weeks ago, which has dropped sharply since then, but are eyeing up the November contract there too.

4. This modest pro-risk tilt - after a period of assiduously avoiding it - has been informed both by the data but also by the pricing of US growth risk. With 10-year yields at 2.50% a couple of weeks ago, we argued that our US view was too far on its way to be priced to make it easy to position for an absolute slowing in the US. Francesco Garzarelli and team argued at that time that the extended G3 bond rally from April was showing signs of exhaustion, both technically and fundamentally, as consensus expectations for growth and inflation finally fell. Their latest Bond Snapshot provides a very comprehensive and concise view of their framework, which continues to be extremely convincing. With the G3 move losing momentum, they recently highlighted the opportunity to be short rates in countries where domestic demand is holding up well and we have recommended paying 5-year AUD rates since just before payrolls.

5. It is no accident that somewhat greater near-term comfort in the US outlook is seeing us look for opportunities outside the US itself. Our US growth views are still not fully priced, our forecast for yields are once again a little lower than current levels and our worries here remain central to our view of the world. But our forecast views of better-than-expected growth views outside the US are equally deliberate (though we find ourselves frequently asked!). As Thursday's Global Markets Daily described, we think the market is underestimating the prospect that a US slowdown has less impact than expected on much of the rest of the world. Judging the degree to which the rest of the world will be hurt or not by sluggish US demand arguably has less to do with who is driven by the US than by who shares US vulnerabilities. The basic story here is simple: the US had a housing bust; most of the rest of the world did not. And we think this will matter for the path of relative recoveries, just as it did when the bulk of the English-speaking world separated unusually from the US tech bust in 2001-04.

6. While our forecasts are for better outcomes across much of the world, from a trading standpoint, we have preferred to focus on the smaller G10 and EM universe. Those economies most clearly lack the combination of housing problems, banking system stresses and constrained policy that are the heart of our concerns about the US (we have been short MXN/CLP for some time as a 'risk-neutral' version of that differentiation). Within the G10, Australia's data has been clearest and we are backing forecasts here both in rates (where we expect an October hike) and in FX, with a recent short EUR/AUD recommendation. But the stories in Sweden (where strong data has been helping EUR/SEK to fresh lows), Norway and even Canada also look increasingly interesting. Switzerland shares in this theme too, though the market has moved much further already to price our views there. By contrast, although we still expect above-consensus growth in the UK and Eurozone, the combinations of fiscal consolidation, significant house price declines in places and bruised banking systems make it somewhat harder to judge if they belong as firmly in the positive camp here, though some local equity markets (DAX, FTSE) are clearly more globally exposed.

7. The EM world arguably has even fewer parallels to the US than the smaller G10. With tightening underway in many places, and policy still effective, external weakening can - to a degree - be offset simply by backing away from policy tightening, a dynamic that we have already seen in Brazil. The biggest issue of course is how the Chinese economy "lands". The weekend's data on that front have been encouraging: a significant sequential bounce in IP growth, the area where slowing was most visible, and a sharp increase in M2 growth which also hints at easier policy. Cross-currents over energy shutdowns and bank capital requirements have muddied the waters, but our core view remains that China's growth path will be better than expected. With improving Chinese data and US mid-term elections approaching, pressure on the CNY is likely to increase again. We saw a sharp drop in the fix late last week and remain short USD/CNY forwards, which amongst other things are a cheap option on USD weakness. Better China data and pressure on Asian intervention are part of the rationale for a short INR/KRW trade that we put on overnight.

8. While "decoupling" in the G10 is likely to play out through rates and FX, it may be that the EM version has more of an equity flavour. As Themos Fiotakis pointed out in last Tuesday's daily (and several other dailies reflected), ultra-low G3 rates and uncertainty over the US outlook are keeping EM rates lower than they would otherwise be (one reason why we have found it hard to pay rates successfully even in the stronger-growing EM markets). They may also make central banks in the EM world more reluctant than usual to allow rapid FX appreciation. But if the consequence is a policy stance that is easier than it 'should' be, local asset appreciation may be the result, as it has been in places already. EM equities have outperformed the G3 for several months now, undoing the underperformance of the first five months of the year. We think this is likely to extend.

9. Related to the notion of easing, the focus on QE2 remains intense. As Jan Hatzius described in his latest US Views, the latest data has made it even less likely that the FOMC moves in this direction on September 21. But we do think that the ongoing sluggishness of growth and further downward revisions to their own views will see them ease later this year or early next, likely through UST purchases. This is likely to be a more difficult and less effective policy than before, as Jan described, given both that credit spreads are already very narrow and that the pure impact of lower rates on the economy is lower than when households have substantial positive home equity and credit channels are fully open. But Jari Stehn's work in the area still provides a good guide to the efficacy of asset purchases and suggests not simply some success in pushing yields lower, but a significant impact on both equities (up) and the USD (down) from the first round of QE. Of these channels, arguably the least open to debate in its efficacy is FX weakness. And since our own views already push in this direction (as the latest FX monthly clearly described), this may be a more attractive way to position for QE2 than the more complex balancing acts for longer-dated bonds and equities.

10. As the FX monthly also notes, the problem with USD weakness as a trading theme is that it is currently hard to implement it without taking on "pro-risk" exposure. This was part of the attractiveness of funding out of EUR earlier this year. These correlations could change with a renewed bout of distinctive US growth weakness and easing. But they do point to one important implementation and hedging challenge currently. In the first four months of the year, when the European sovereign crisis was the dominant risk, funding from EUR or protecting portfolios with short EUR positions was hugely beneficial. As the focus shifted to the US slowdown in May/June, the optimal offset to pro-risk positions came from long positions in US bonds and the USD underperformed. Now the near-term situation is muddier, both US growth risk and European sovereign risk are on the table again and both are also quite well-priced. We believe in USD weakness as a medium-term theme, and our view of the EUR over longer horizons is more upbeat. But we can see the merits of funding out of EUR or a combination of USD and EUR, matching the major short-term risks that we see.

11. Politics is back in focus. In the very near-term, tonight's DPJ presidential elections will be closely watched. DPJ surveys over the weekend suggest the race will be very close. If Ichiro Ozawa wins and becomes Japan's next Prime Minister, there is a reasonable chance that he would try to promote more expansionary fiscal and monetary policies, with the latter possibly including increased pressure on the BOJ to weaken the JPY. Even if he does not, his influence may be felt in terms of the new administration's policy, though we continue to think without a significant shift in BOJ policy, a big turn in the JPY is unlikely. The US mid-terms are also a growing source of debate, with the latest polls favouring the Republicans. Beyond the implications for the CNY, the situation remains quite fluid. The conventional wisdom that a divided government would be welcomed by markets is complicated by the need for additional fiscal stimulus to avoid or mitigate a significant passive fiscal tightening that is in the works as a result of the fading of the stimulus measures enacted in 2009 as well as the expiration of a portion of the 2001/2003 tax cuts.

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