Tyndall Monthly Commentary

Justifying the Rally

Tuesday, March 6th 2012, 12:02PM

by Andrew Hunt

If one casts one's mind back to a little more than 12 months ago, global financial markets were in a buoyant mood. The global economy was believed to be expanding and markets almost perversely were taking heart from the fact that many central banks were feeling confident enough to either remove their "special or extraordinary stimulative measures" or to even begin tightening their interest rate policies in the case of Trichet's version of the European Central Bank. The Reserve Bank of Australia was also raising rates and, prior to the earthquake, it had been assumed that the RBNZ would follow suit as the NZ economy firmed. Optimism was rife and markets seemed to have become almost "Teflon-coated" when it came to bad news - good data was being seized upon but bad news was being ignored. As markets were subsequently to find out, the reality of the situation was very different and the rally was not being driven by economic fundamentals but rather by simple hope, relatively undemanding market valuations and a great deal of borrowed money as funds (including even once-conservative pension funds in the USA) sought to gain positive returns through the greater use of financial leverage. Unfortunately, we today find ourselves asking whether history is once again repeating itself and whether the recent rally in markets is simply yet another triumph of hope and valuations (although not, on this occasion, leverage it seems) over reality.

If one looks at the global economy from the standpoint of the various and now high-profile purchasing-managers-type diffusion indices and even the ultra-short-time-span industrial production data, one can form a view that despite the concerns of the cassandras (and most policymakers we have encountered), the global economy is shrugging off the gloom of 2011 and moving forward, led, it seems, by the USA. It is also significant that the (albeit still only partial) revival in manufacturing growth and output expectations is leading to a renaissance in several labour markets around the world. What is less clear is whether this revival is a deliberate acceleration in the economy or simply a reaction to the overdone weakness of October-November, the unusual weather patterns, or the timing of the Lunar New Year that dominates Asian trends at this time of year.

In fact, we suspect that part of the optimism expressed in many of the confidence indices tells us more about human nature than economic conditions. Recently, we addressed a small business group in the depths of suburban London and found ourselves explaining just what might have happened to the Global Financial System and the global economy had the Euro fractured unexpectedly in 2011Q3. We drew attention to the 10 times global GDP that was outstanding in OTC derivatives last (northern hemisphere) autumn that might not have settled in the event of an EUR breakup, what this would have done to the banks and how this would have affected the availability of even working capital to real world companies, such as those represented in our meeting. They were predictably horrified at what might have come to pass last year had the Euro Crisis accelerated further. Had our audience been leaders of large German or US companies, though, then we suspect that we could still have scared them with the actual numbers but they would already have known the general themes and they would also have been aware that October-November witnessed something of a rout in Europe's economy.

Since then, there has been little or no growth in Europe and, on a three-month basis, most measures of output and spending are still down but the rate of descent has clearly slowed and the ECB's various support measures seem to have patched up at least the financial flows component of the Euro Mess at least for now, even though the politics seem to be worsening on a daily basis. Given, though, that a politically-inspired breakup of the Euro in perhaps 2013 could be arranged in a more orderly fashion than a financial crisis-driven one, then even if this outcome were to occur, it might be less serious than what might have occurred in 2011.

Therefore, given this sense that we have now pulled back from a potential catastrophic event (if only to a recession/political crisis event), we are not surprised that industrialists feel a little better about the future and their optimism has improved, even though as the influential IFO index reveals, actual current business conditions have continued to soften, albeit at a more modest pace. Consequently, we continue to believe that the revival in the Euro Zone and other confidence indices is merely a natural human reaction to the news that the economic world is not about to end tomorrow, rather than a sign of necessarily improved current economic conditions.

Moreover, if one observes the household disposable income data, one finds that the recent improvement in the labour market has not been a "game changer" and that consumer sentiment and spending is still essentially weak. US retail sales growth is proceeding at a decidedly average pace and although the UK's data is a little better, the retail spending data across Europe and Japan is weak. There is also evidence from the Asian data and even the US's own GDP figures that global finished goods inventories are at a high level as a result of the mismatch between production sector optimism and weak shipments data. Meanwhile, Asian trade prices look set to suffer another period of deflation and shipping rates have sunk to crisis-style lows.

Therefore, it seems that, quite legitimately, one could either have an optimistic view of the global economy based on the back end of the economy/production surveys or a more recession-like view based on the consumer/sales/retailers' data series. There are no prizes for guessing which the world would rather be true and the finance sector for reasons of its own business needs has obviously chosen the more optimistic view as its base case, judging by the recent performance of the markets.

We would argue, though, that it will become increasingly apparent during the second quarter that unless a new era of rising leverage emerges (and there are few signs within the available money and credit data series that this is happening at present despite the encouragement of many of the central banks and Mr Bernanke in particular), financial markets are going to have to take a view as to whether manufacturers have been too sanguine or retailers and consumers too cautious.

Specifically, we would suggest that as we get clear of the data distortions caused by the oddly-timed Chinese Lunar New Year, we suspect that the various March-April retail data releases will prove crucial in describing who was correct: either the consumer spending and new orders data must rise appreciably over the next two months (and thereby justify the markets' optimism) or the recent production/employment revival will have to be reversed, presumably to the financial markets' chagrin. At present, we would argue that markets are tending simply to assume that the former scenario will come to pass but, on the basis of the current newsflow from the retail sectors and in addition the recent rise in oil prices, markets may yet find themselves disappointed and the first quarter rally may once again turn out to have been a false start.

Andrew Hunt

International Economist, London

Andrew Hunt International Economist London

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