Economic and market themes: 2014-01-31

Themes for today:

• US economic growth is poised to be decent in 2014
• Europe will recover but not at the same pace as the US
• EM is really a China contagion story. I am concerned but not alarmed
• Watch high risk sectors like leveraged loans or auto ABS for impending market volatility signs
• Jobless claims suggest peak growth in the US was Q3 2013

I am going to make a habit of writing posts that give a roundhouse view of the economic and investment themes to compliment my single theme posts. I think connecting the dots between various issues is a good way to look at the markets and the economy. So I feel I often miss out on the ability to say something on important topics in my mon-themed daily commentaries. So here goes.

United States. Right now, the consensus view is that the US is in a recovery that is gathering pace. Under this view, the yearly second half slowing that required quantitative easing is over. So 2014 is poised to be a good year economically. Only some dissenting voices voice concerns. My view is closer to the optimistic view, namely that the pace of US expansion is going to be good. Q4 saw 3.2% growth when I had been saying pre-Christmas that growth looked more like 1.9% to 2.0%. As the holiday season kept getting better, I expected the numbers to be better as well. Yes, this 3.2% growth includes over 0.4% of inventory builds. But the 2.7ish% growth ex inventories is on the high side for what the US economy has been doing. And this comes after a 4%+ print in Q3.

Given the dynamics in the US economy, it is entirely possible that 2013 turns out to be the 1994 equivalent, a mid-cycle tightening period that cyclical agents overcome as the credit cycle loosens. I have said we are at an inflection point on this score. But most of the data supports an upbeat view. US banks are easing credit standards and loosening limits on credit. All this is happening so fast that the OCC is afraid of a credit bubble. And while I believe that fear is warranted, over the medium-term that suggests a credit accelerator dynamic is at work in the US. Moreover, jobless claims at 330,000 support the idea that wages and earnings will grow enough to support spending irrespective of the housing and stock market. I believe we are past cycle lows in jobless claims, something that would suggest US GDP growth has peaked. But the credit accelerator dynamics change that calculus.

Finally, there’s housing. We know stocks have been up. But home prices in the US rose the most since 2006 in the most recent data, according to Case-Shiller. 2013 was a very good year. That says housing is a tailwind for the economy. Moreover, if you look at metrics like price-to-rent, the US housing market is not in a bubble. Most of the growth to date has been mean reversion. The question is what happens going forward. If we have more years like 2013, we will have a bubble on our hands. But nothing indicates we are moving in that direction. For example, while bank credit is being loosened, the Wall Street Journal pointed out that “the OCC noted one exception to the trend: underwriting standards for home-equity loans have tightened.” Moreover, pending home sales dropped sharply in December, particularly in the West. Bottom line: housing is doing OK but it is not a bubble. It will support continued recovery.

So my view on the US economy is positive.

Europe. I will have less to say about Europe here because I need more data. But my view hasn’t changed considerably. When I first signalled that Europe was going to recover in June, that was an outlier call. But now everyone is on the European recovery bandwagon. The data support this. We are not going to see US-level growth but we are going to see growth and we should start to see a decline in unemployment in Spain in particular.

The thing to be bullish about here is the bottom feeding going on. In Spain, foreign investors are moving into the market and buying stakes in the property and construction sectors. That tells you the sector has bottomed. Home prices are rising and this means fewer credit writedowns by banks, making the credit situation more sustainable.

Back during the Italian crisis in November 2011, I wrote why Investors will buy Italian bonds after ECB monetisation and the same logic holds for Spain:

If a central bank guarantees investors credibly that they can invest in certain debt instruments and not suffer principal or interest repayment risk, but only currency and inflation risk, some investors are almost definitely going to buy the debt instruments with the greatest yield pick up. Put another way, the only reason not to buy Italian debt at 2 or 300 basis points over Bunds, or Greek debt at 3 or 400 basis points over Bunds is because those governments are not credibly backstopped by the ECB.

It was only when we saw the OMT threat last year that people took the ECB seriously. The backstop for Spain and Italy is in and their yields have plummeted as a result. Now in terms of credit, this is important because the Spanish banks are reaping billions from their sovereign bond holdings. The bank-sovereign link may not have been undone. However, with an ECB backstop we are seeing a virtuous circle between the two instead of the vicious cycle we saw as default and redenomination risk was on the table. All this means then is that Spanish banks have been recapitalized through the back door. I expect when the ECB’s bank review comes out the problem banks will be in France and Germany where there have been no sovereign bond dividends and no capital raising campaigns and no credit writedowns. Periphery banks have been through the wringer and may end up looking better than core banks.

Some of this is mere accounting gimmickry but it works because it allows the real economy to breathe and for credit to flow. I see the most positive outlook relative to expectations therefore for Spain. Housing recovery, sovereign debt yield drop, credit loosening, and foreign capital flows will all aid a real economy recovery. Greece, Portugal and Italy are in a worse position with unique challenges each.

Emerging markets. Since I have been writing about this fairly extensively, you know my view here. It is mostly about Chinese rebalancing and the knock-on effects of that rebalancing. Frankly, I have not been alarmed by what is happening in emerging markets because I feel like those economies are less unbalanced than they were during prior crises. Countries like South Africa, Argentina or Turkey are special cases. But the Magnus interview has raised my level of concern and I found his belief that we are in a crisis alarming. So I am on alert now.

I am looking at India, Brazil and Russia, the other three BRIC nations for signs of stress. Basically, if these three countries can weather the storm then the blowback to developed market economies and financial markets will be muted. Of those three, I am most concerned about Brazil. India has gone through their crisis phase and weathered it. Raghuram Rajan, the new central bank head, really has credibility outside India and that gives the country breathing room on the currency front. Inflation needs to come down before we can say “all clear.” In Russia, we see a country with a massive amount of foreign reserves. They are rock solid on that front. And oil prices remain elevated. So I am not concerned that Russia will be a flashpoint.

Brazil is a problem though. It’s economy is tanking with negative GDP prints. Last year, there was also widespread social unrest and the inflation picture looks worrying. External liabilities to global banks have nearly quadrupled over the last decade. And so you have to be concerned that hot money would be an issue if Brazil cannot grow the economy and ease inflation. I am concerned that Brazil is raising taxes right now when the economy is doing poorly. Let’s see if this puts a halt to the inflation.

Conclusion. So I have run out of time here. But my general tone was upbeat. I see positives in Europe and the US. I am concerned about emerging economies though and I think this is the area to watch for signs of global economic weakness. This picture is broadly supportive of equity markets and bond markets should not sell off unless the economy accelerates quicker than anticipated. One area to watch for signs of excess – and credit acceleration is junk bonds and leveraged loans because spreads are tight and deal terms suggest excess. If we do get a jolt in the developed economy, it will be via the riskier sectors like asset backed auto loans, student loans, high yield bonds or leveraged loans. All of these markets show signs of excess that can only be prevented from unwinding by continued positive real economy data. In terms of real economy data, continue to watch jobless claims for signs of peak growth. Claims are indicating that Q3 was peak growth and that growth will decline from here in the US. We will need to see accelerating wage growth or credit growth to overcome the mean reversion in jobless claims data.