Sunday, 19 June 2011

Cyclical view

For good two months now, economic data has been coming in weaker than expected. This logically leads to consensus growth downgrades, however so far these growth revisions have been concentrated in the 1st half of 2011, and have not been reflected in the 2nd half growth expectations as well as FY 2012.

As can be seen, after a weaker 1st half (1.8 and 2.45) consensus is expecting 3.2 in H2 and 3% in 2012 (which hasn't moved since late last year).

If this soft spot becomes yet softer, there is every chance that it will start affecting growth expectations further out, and that will lead to weaker risk assets and a stronger USD (at least absent a vigorous QE3 response). There is good reasons to expect further poor data in the near term, and I would expect the markets to start discounting the risk of a more serious growth deceleration (lower stocks, higher volatility and credit spreads).

Most market professionals recognize that the ISM Manufacturing survey (in particular the New Orders component) is one of the best global leading indicators. In the beginning of every month when it is released stocks and bonds swing violently depending on the surprise direction. For two weeks leading up to the ISM release, regional surveys are made available, which give us some insight what to expect. Thus far the Philadelphia Fed and Empire State Surveys turned out very weak, pointing to a June ISM reading of around 46.3 (44.5 if we were to use the "Philly" only). Even adding 3 points to this estimate, which is the divergence we had between the ISM and the Philly+Empire proxy in this cycle, takes us to <50, ie economic contraction.
So, there is every chance we get a sub-50 reading on the ISM, when it's reported on the 1st of July - I think that can spook the markets. Not only would it be the 1st reading since mid-2009 indicating contraction, but the idea that it's just a temporary slowdown, mostly Japanese supply chain driven, would have to be reviewed. The street is is still quite bullish on the economic forecasts (as the table above illustrates), and the downgrades have not yet been made. This is very well illustrated by our friends at Citi.
The graph shows, that based on a model (which I suppose, uses many of the economic indicators discussed here), growth forecasts are currently too high by a sizable margin.

Finally, it's worth noting, that my favorite European leading indicator - real growth of M1 - has peaked in mid 2009, and the decline since, indicates an imminent drop in the IFO (leading index) and the growth pace in the core European countries (no, not the periphery - Germany, France, Sweden etc)
This indicator has done a good job since the early 90's. In the previous cycle it lead by about 2 years, and based on that lag, we should see a lower IFO in the months to come.

Conclusion and implications: sell the EUR, sell stocks or go short cyclicals/defensives, and wait.

Remember what Warren Buffet once said - Money flows from the impatient to the patient - so wait and be patient - the opportunity to go long your favorite long-term plays, will certainly come!

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