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March 15, 2012
Topics: Is US data as good as it looks? Is Chinese data as bad as it looks? Is European data as bizarre as it looks?
What a diff’rence a day makes. Ever since the ECB giftwrapped
650 billion Euros for EU banks, the news has been
pretty good, particularly in the US. Most of the market’s
focus is on the US consumer, for the simple reason that US
households are the largest single economic force in the world
(see table). Even after deconstructing the labor report for
signs of false positives 1 , the message is clear: US job markets
are gradually getting better, and so is spending. The capital
position of US banks is in good shape 2 , so we expect access
to credit to remain easy 3 . A US GDP growth rate of 2.25% is
still below trend, but a long way from the unavoidable
recession articulated by the ECRI last fall. I agree with those
who think the US economy could not withstand a withdrawal
of stimulus right now, but I also do not see the Fed actively
withdrawing it. Whatever rain dance the Fed is doing to
keep inflation low, they better keep doing it.
A chart I saw on the history of jobless claims (below, left) was meant to show how good things may get. In the prior 3 business
cycles, when continuing claims fell through 2.2% of the labor force (1982, 1993, 2003), it was a great time to add risk in
portfolios. Improving claims signaled that the business cycle was picking up enough steam to be self-sustaining, and last week,
the US crossed through this barrier again. But as Big Bird used to say, one of these things is not like the other: the US
primary budget deficit which supports this recovery is a bigger now. So, the US economy better improve markedly in order
to pay the freight. When will this chart on the primary deficit (below, right) matter to financial markets? Only when it becomes
a binding constraint, either due to a lack of demand to finance the deficit at current yields, or due to the economic cost of closing
it. The timing is uncertain, given Central Bank purchases of Treasury bonds, and a Congress which may leave the problem for
another day (or generation). I lose a lot of sleep over this, but I don’t know a lot of other people that do. As discussed last
week, portfolio allocations given today’s private and public sector realities vary substantially across wealth management firms.
Ours rely on hedge funds, credit and real estate as complements to public and private equity.
In past cycles, claims were a great market signal
Continuing claims as a % of labor force
5.0%
4.5%
4.0%
3.5%
3.0%
2.5%
2.0%
1.5%
1.0%
1967 1972 1977 1982 1987 1992 1997 2002 2007 2012
Source: Department of Labor, BLS, Empirical Research Partners.
The importance of the US consumer
Billions of USD
Private
Consumption Investment Gov. Net
Spending exports
US 10,417 1,818 3,020 (500)
Asia 8,231 4,614 3,449 424
Asia ex. CN/JPN 2,761 597 1,482 134
Japan 3,501 1,185 1,175 58
China 1,969 2,832 792 232
Europe 9,670 3,148 3,662 130
EMU 7,145 2,386 2,704 145
Latin America 2,747 754 1,010 28
Source: Haver. Data as of Q4 2010.
Paging Dick Cheney: Do Deficits Matter?
Deficit ex-interest, percent of GDP, seasonally adjusted
8
6
4
2
0
-2
-4
-6
-8
-10
-12
1954 1967 1981 1995 2008
Source: CBO, BEA, OMB, J.P. Morgan Private Bank.
1 Our chief economist Michael Vaknin has analyzed the various seasonal adjustments that the Bureau of Labor Statistics uses when it reports
payrolls. After adjusting for better weather, the Lehman shock and other factors, payroll growth does not look quite as good as reported, but
is still positive. The trend is supported by the latest Manpower surveys, Institute for Supply Management surveys, JOLTS surveys, etc, all of
which show growing demand for labor. Even state and local government firing has finally come to an end, which was a constant fixture of
the last two years. So far, hourly earnings remain very weak, and typically do not grow until later in the cycle.
2 The latest US bank stress tests were pretty stressful. Two-year loss assumptions applied by the Fed were higher than those experienced
during 2008 and 2009, and comparable in almost every category to realized losses during the Great Depression. Almost every institution
passed the test, and even the ones that didn’t are expected to reach required capital levels in short order. US banks have sharply reduced
reliance on “hot money” (time deposits, commercial paper and repo), relying instead on core retail deposits to finance their balance sheets.
Comparing the rigor of US and European bank stress tests is like comparing the rigors of actual football to Wii football.
3 So far, net household borrowing other than student loans is weak; loan growth is almost exclusively from companies rather than households.
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March 15, 2012
Topics: Is US data as good as it looks? Is Chinese data as bad as it looks? Is European data as bizarre as it looks?
There’s also some good news on the global profit outlook, or at least an end to the bad news. A measure of global earnings
revisions had been running negative for 40 weeks in a row until last week when it turned slightly positive. Other corroborating
evidence comes from conversations we’ve had with private equity firms, whose portfolio companies are generally planning for
10%-20% increases in capital spending budgets this year.
Global earnings revisions vs. global equities
(# of upgrades minus # of downgrades) / total revisions Level
1,575
0.4
0.3
0.2
0.1
0.0
-0.1
-0.2
-0.3
-0.4
-0.5
-0.6
-0.7
MSCI World
Index
2008 2009 2010 2011 2012
Source: Citigroup, Bloomberg.
1,475
1,375
1,275
1,175
1,075
975
875
775
675
Unfortunately, the ECB can't create jobs
Employment, percent change, QoQ, saar
3%
-3%
2005 2006 2007 2008 2009 2010 2011
Source: Eurostat, Bundesbank.
After four years that challenge some of the basic assumptions of efficient markets and laissez-faire capitalism, there is a pent-up
demand for normalcy among individual investors, money managers, CEOs, corporate treasurers, pension funds, regulators, etc.
Through massive money creation, Central Banks have provided the veneer of normalcy which has allowed the private sector to
get moving again in the US, or at least in the case of Europe, to stop declining. Markets love it. Is the ECB’s Mario Draghi a
genius? Only time will tell. The last time the term Maestro got thrown around, it was a case of premature exaltation.
The latest from Europe: my head is hot and my feet are freezing
Angela Merkel described Europe as being “a good way up the mountain path” regarding the debt crisis. Courtesy of the ECB,
there has been a dramatic improvement in sovereign and bank debt markets. However, in the real economy, improvements are
much harder to find. In contrast to improving labor markets in the US, Europe still looks pretty bad outside Germany (see chart
above; the declining Euro Area line includes the better data from Germany). Other variables related to production and
consumption show the same regional divergences. The challenge for Spain looks particularly daunting, given a less open
economy than countries like Ireland, escalating costs associated with bank recapitalization and municipal funding shortfalls, and
the likely continued withdrawal of foreign capital from the private sector. Even with continued German assistance, it’s going to
be a long and freezing mountain hike for the periphery.
On investments, we saw a lot of things we recognized in a 76-page Morgan Stanley paper on bank deleveraging and real estate.
This has been one of our primary investment themes over the last year. MS estimates 3 trillion Euros of deleveraging by
European banks in the next 3-5 years, even with ECB repo facilities slowing the pace of asset dispositions, and a more
relaxed approach to Basel 3. Europe’s greater reliance on banks to finance commercial property investments (versus capital
markets) is a primary driver here. One example: amazingly, Spanish banks have more domestic commercial real estate loans
than UK and German banks combined. There are likely to be opportunities in purchasing loan portfolios, and in providing
capital to refinance existing loans. In an environment of low growth, perpetual austerity and rising consumer stress, and the
lingering possibility of a devaluation in some countries, buyer portfolio discounts need to be large enough to make sense.
Where is China heading?
There is a roiling epistemological debate as to whether China’s current decline is structural or cyclical. As an aside, two of JP
Morgan’s investment banking analysts (one an economist, the other an equity market strategist) have taken opposite sides of the
debate, which is in and of itself a healthy thing. Like the question about whether Italy has a liquidity crisis or a solvency crisis,
the answer depends on your definition, and definitions can change depending on how governments respond. On the following
page, we include our own China Dashboard we use to track what’s going on. Now that we have February data as well as
January and can adjust for some of the New Year effects, it’s pretty clear that China is slowing. Markets are still nervous, since
Premier Wen stated that the government is still concerned about elevated home prices, and that they will continue tight policies
on property markets. Home price to income ratios in some major cities exceed peak 2006 California levels.
But with the collapse in Chinese inflation, the government has room to re-stimulate a bit. Recently, the Chinese government has
injected more liquidity; expanded the quota for foreign equity investment; cut bank reserve requirements; delayed tighter capital
2%
1%
0%
-1%
-2%
Germany
Euro Area
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March 15, 2012
Topics: Is US data as good as it looks? Is Chinese data as bad as it looks? Is European data as bizarre as it looks?
adequacy rules; created a program through which municipalities can issue bonds with government guarantees (rather than
having to borrow from banks); eased first time homebuyer restrictions; and injected capital into its biggest banks. What the
China debate is really about is whether these measures will reinvigorate growth or not. Since much of the recent
slowdown was self-imposed due to inflation concerns, it seems reasonable to us to expect the Chinese economy to respond
positively to stimulus should it be reapplied. We are not big buyers of Chinese onshore equities for reasons we have
explained before, but we do rely on 7%-8% Chinese GDP growth to fuel economic activity in Asia that underpins many
of our investments there. As things stand now, we see no reason why this growth target will not be achieved.
Chinese economic monitor, percent change*, YoY, sa, 2006 to present
Total loans
CPI
Exports
PMI
Money
supply
Non-food CPI
Retail
sales
Passenger car
sales
Fixed asset
investment
Housing price to
income
Shenzhen
Beijing
Shanghai
IP
Electricity
production
Cement
production
Steel
production
Source: National Bureau of Statistics, PBOC, China Automotive Information, China Economic Information Network, CLSA-Markit, Haver Analytics. J.P. Morgan
Securities LLC, ISI Group, J.P. Morgan Private Bank. * PMI data are index level. Housing price to income, cement production and steel production are as of
Dec. 2011. All the other data are as of Feb. 2012.
Michael Cembalest
Chief Investment Officer
“What a diff’rence a day makes”, Dinah Washington, 1959, Mercury Records
“Banks Deleveraging and Real Estate”, Morgan Stanley Research, Francesca Tondi, March 15, 2012
The ECRI (Economic Cycle Research Institute) claims papal infallibility on its historical recession predictions. ECB =
European Central Bank. EMU = European Economic and Monetary Union
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