Tuesday, February 14, 2012
Well TMM must apologise for their laziness this year in getting their Non-Predictions out. To be honest, we have found it pretty hard to get excited about anything: the backdrop since the beginning of the year of improving data, particularly in the US, sitting uncomfortably aside continuing Eurobllx is unchanged. TMM really have run out of ways of writing the same thing over and over... what can we say? Please Mr. Market, can we have something new to get our teeth into? Anyway, we managed to drag our sorry arses out of our lethargy and do some work.So TMM present, embarrassingly late, their 2012 Equity Non-Predictions.
1) EM Equities will NOT repeat 2011's under-performance of DM Equities.
Last year, TMM judged the worsening inflation picture in Emerging Markets and associated tightening would prove challenging for EM Equities, and the mid-year spike in risk aversion dealt an even bigger blow to the asset class as cross-border equity flows reversed for two consecutive quarters - an event not seen since 2008. But TMM reckon that the picture looks a bit better than prices would perhaps reflect, even accounting for the large move higher seen since the beginning of the year. TMM hold that EM equities are rarely a trade on "the next big thing" and whenever they hear market participants begin to talk about "decoupling", large alarm bells go off in their heads. Instead, TMM reckon that EM/DM relative equity performance is driven by a combination of relative growth, inflation & money supply growth, as well as the global inventory cycle. The last of these - despite both the gallant attempts of the BRIC crowd and Europe-bears to argue otherwise - seems to be purely driven by the US.
Using this basic framework, TMM have been able to describe a good part of market moves (see below chart). In 2007-8, the Great EM Decoupling Experiment first led to very strong EM out-performance, before the inevitable global linkages branded this experiment a complete failure, as EM equity markets crashed, playing catch up to their DM cousins. While the fit is not perfect, since mid-2009, the model has basically come back into line with performance, except for the past six months - driven, as noted above, by cross-border repatriation spurred by Euro-break up fears. But in recent months, TMM judge the EM growth/inflation mix to have improved significantly, as base effects left over from the Arab Spring and momentum in food prices wane and the US inventory cycle spurs renewed production (and export growth) in Asia. And even though EM equities have put in a sterling performance this year, TMM's model would suggest the out-performance has further to go.
TMM were lucky to catch most of the move up in H-Shares in January but are now flat, hoping for a pull-back in order to reset such trades expressing this theme.
2) Equity Bears will NOT stop trying to argue that earnings will fall as a result of margins contracting from multi-year peaks, but S&P earnings growth will NOT disappoint the consensus of 5.5%.
If TMM had a Pound for every time they have heard the argument that earnings have to fall as a result of margins peaking from multi-year peaks, they would have little need to stay in the hedge fund business. The trouble with this argument is that (i) TMM have been hearing it for many years (which, admittedly, does not mean it is wrong), and (ii) certainly over the past 15 years, TMM reckon the evidence suggests that it is the economic cycle rather than margins that determine whether earnings fall or not. The below chart shows TMM's naive earnings model which uses ISM, input/output prices, corporate financing costs, wages & the Dollar to try and explain earnings growth. The model missed the 1998/9 Russia/LTCM-driven fall in financials' earnings (i.e. - not having a financial crisis-type variable in it to explain investment bank losses), but largely appears to do a reasonable job. So TMM's point here is that if you are looking for earnings to fall, then it's going to come from either another financial crisis (probably in Europe) or a double dip back into recession.
As readers know, TMM reckon the US recovery now has exit velocity, so they judge the latter as being unlikely. Regarding the former, TMM have noted before that it is entirely rational for markets to price in the very large tail risk emanating from Europe, but they cannot be fixated by it permanently. We judge a good deal of the global de-rating in the latter half of 2011 as being related to that, but as time passes and (hopefully) growth returns to Europe, that risk premia will be taken out, sending the S&P500 from the 12-13x earnings range to the 13-14x range. For the time being, the strategy of buying dips in the S&P seems the right one.
3) The ASX 200 will NOT reverse its poor relative performance and will remain a laggard of global equity markets.
This particular Non-Prediction is related to one of TMM's rates Non-Predictions: "The RBA will NOT cut more than 25bps and the Cash Rate will also NOT finish 2012 below its current level of 4.25%". Last week's RBA decision seemingly confirms the reluctance of the RBA to cut, and with the currency sitting close to multi-decade highs it is clear that monetary conditions in Australia are relatively tight. This is not surprising to TMM as, one of their ex-colleagues one surmised, the RBA care first about China, second about the global environment (i.e. - Europe, right now) and last about Australia. Sorry, TMM will correct themselves - they care about Australia *second to last*, with New Zealand occupying the last slot. But cheap jokes aside, the anecdotes regarding the potential hollowing out of the domestic economy by the mining sector - i.e. Dutch Disease - are not to be ignored.
The trouble is, that these effects tend to take years to play out in their entirety - for example, witness the crowding out of both the domestic & export sectors that high financial sector Terms of Trade in the UK managed over the past decade. It took many years for the over-valued Pound to eventually collapse. That experience (TMM tried shorting Betty repeatedly between 2005 & 2008 to no avail) forced TMM to look elsewhere. If you think the domestic economy is getting smashed, then you need to trade something linked to the domestic economy. The closest liquid proxy seems to be the ASX. It is not perfect as still close to 30% of its weighing is materials/energy, and whether true or not, the perceived link to China could well give it a lift should the Chinese economy roar back above trend again. TMM haven't completely figured out their implementation here, but would assume that selling ASX vs. US/Japanese equities and buying calls on Chinese H-Shares could be one good way of playing this.
And with that, TMM will wish their readers a Happy Valentine's Day.