US Politics stretching equity catapult elastic.

The broad thesis that TMM have been running over the last few months is that the world continues to recover from the great financial crisis and we don't expect that to stop.  If we were to look at the recovery as a Formula 1 race then though everyone is generally moving forwards, emerging markets have pulled into the pits to refuel, Indonesia and India having been found to have severely overheated. Europe has just left the pits after having had most of its bodywork patched together after a nasty crunch and is catching up fast. But the leader over the last 2 laps, the US running on natural gas, has suddenly pulled over. Not due to equipment failure but  to an insane in-fight between its own management team leaving the leading driver under instruction to shut the car down. Team Macro Man think that the Fed should do a "Vettel" and ignore team instructions and just get on with winning the race.

Early August had a definite feel that good news was pretty much fully discounted with respect to direction (but not yet fully priced - more later) and that we should be looking for something for the disasternistas to get their teeth into in order balance things up and wow hasn't this US showdown been just the ticket? However we maintain our dogged view, last employed during the European crisis, that when politicians are close enough to the edge of mutually assured destruction they WILL get their acts together. The frightening part for everyone else is seeing them dance so close to the edge.

So where are we in the US? The political risks appear to be limited now to an extended government shutdown. GS estimates something like ~15bps off 4q GDP growth per week of shutdown, but it will be made up when the government re-opens, so it’s not clear how big of an impact it will have. But the main driver for the recovery of markets is the removal of both the default tail risk ( cf. European response to OMT) as well as the risk from a sudden stoppage in entitlement programs.

It seems unlikely that the Fed will taper while the government is shut down and we have to cope with a lack of reliable macroeconomic data. People have also noted that even if the government IS reopened shortly, much of the released data will be affected by the shutdown in various ways anyway resulting in noisy feedback loop debate as to what reality is.

Given that the FOMC minutes showed a fairly close vote towards a taper last month, it seems reasonable to assume that taper mania will be back in full swing as soon as the shutdown is over. Consensus seems to be moving towards 1Q right now, which seems reasonable. But barring a downturn, it seems hard to imagine a substantial fall in yields in the near term. The Eurodollar strip is priced almost to perfection vs the FOMC’s projections after adjusting for a ~20bp spread for Libor-OIS:




What is interesting is that the pace of hikes priced into the market slows starting in 2018, ~5 years forward. There are several possibilities for this, but one may be that Yellen has said in the past (6/6/12, specifically) they she thinks the economy’s equilibrium real Fed Funds rate is probably well below its historical average. She didn’t give a number of course, but with the FOMC central tendency estimate for the equilibrium rate at 4% at the last SEP, there was 1 vote at 3.75, 2 and 3.5, and 1 at 3.25. Note also that in her “Optimal Policy” speech, she has Fed Funds at 3.25 in 4Q 2018.






Watching market response through all of this has been interesting and indicative. Considering the moves in T-Bills and the responses by Hong Kong to haircut them as collateral ( the Swiss considering the same) it looked as though the closest thing to cash and the world's favourite safe haven was doomed to destruction. But relative nonplussed performances of Eur/usd and indeed the non-cataclysmic equity response had us wondering if maybe some Machiavellian political forces were encouraging this run to spur the other side back to the negotiating table. The US10year back to 2.60 can be seen as a return to comfort levels after the last panic spike higher. This leaves us with the view that this US congressional mess is a valley that has to be bridged to higher lands on the other side.

In the meantime, traditional measures make the conditions for equities look pretty benign here, although given the repricing in the VIX, arguably almost all of the default tail risk has been priced out already. BUT, and this is the big but, we are strong believers that in an environment where people continue to have to choose between cash, bonds or stocks, the inflows into stocks will continue. To TMM there is a mismatch between folks talking the equity talk and walking the equity walk,  perhaps because they are afraid of the the micro-analysis telling them that equities are fairly/over/madlyover priced. But if we are to look at how markets have behaved and how the current environment of excess savings chasing minimal returns is playing out, then traditional fine measures will be nothing in the face of sloshing tides of money chasing anything that is simply "going up". (We recommend Izabella Kaminska's great post on yield chasing and bubbles here).

TMM has, as regular readers will know, been a great fan of overweight Europe for the past year or so but popularity is catching up with us and we note that based on forward P/E, the Eurostoxx50 has now exceeded late 2009 levels. Against the S&P, the Eurostoxx is as rich as it was last December, and before that in late 2006.





Now as we said above, this matters little if we are looking for another tidal wave of renewed portfolio switching (this US scenario has offered a secondary "out" opportunity to those having missed the boat re bonds to equities) but it does make us look at reweighting more to US from our very overweight Europe view.

TMM feel that the debt stuff will be resolved, or put on the back burner again European style, enough for a market melt UP into the year end.




And as a footnote - Whilst TMM believe the pricing and distribution of UK's Royal Mail issue was designed to act as ground bait to attract the shoals to take the hook of a trickier upcoming RBS sale, its success has given the UK public's general interest in equities a real boost. TMM reckon that for every cry of "Foul easy profits" from left-wing spokespersons there are a hundred responses - "Easy profits? Where?"
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Anonymous
admin
October 13, 2013 at 12:22 PM ×

Use 2014 eps in stoxx600 for Europe valuation. Still 10% or so versus S&P. then consider that margins are 4% in Europe versus 8% margins in US.

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Jill
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October 13, 2013 at 3:57 PM ×

About the taper...

Global finance chiefs ready defenses ahead of Fed

http://tinyurl.com/mgv38kx

Some thoughts on Ms. Yellen...in her own words:

“For my own part,” Ms. Yellen said, “I did not see and did not appreciate what the risks were with securitization, the credit ratings agencies, the shadow banking system, the S.I.V.’s — I didn’t see any of that coming until it happened.”

http://tinyurl.com/qywrj4n

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Stan Jonas
admin
October 13, 2013 at 7:06 PM ×

I'm not sure where you're idea that LIBOR and what you call OIS are separated by 20 bp's comes from...
Even looking at your pretty chart.. on can see one of two things... but lets look at the simplest...
In December of 2014 3 month LIBOR should be if the FED is on hold... 99.75 or about 25 bp's just where it is now?

December Euro's are pricing as you note 50 bp's

Mumbo jumbo aside... thats certainty of a Tightening by then End of 2014...when the FED and certainly everyone else is trying to convince us that they're on hold far longer...

The real question is what was the market pricing back in September when Dec 2014 Euro's were 99.125 or .88 bp's?


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abee crombie
admin
October 14, 2013 at 1:53 AM ×

who doesnt wanna buy DM stocks? its the only game left in town. EM secular trade has been pronounced dead, though the cyclical one seems to be starting. And everyone agrees rates are rising, just a matter of when.

However that seems a little too consensus for me. US stock market is increasingly led by Momo concept stocks, meanwhile DOW is looking ugly. R2K is near historical expensive, though I do like C's domestic small cap is the new EM theme but 20x for US 3-4% growth (on a good 2014)I just wonder how it all plays out.

I am just watching my spec stocks fly and slowly trimming.

Rosey had some interesting thoughts on wealthtrack. Power to the labour, not owners of capital.

Glad your back Pol.

Any thoughts on Yellen pulling a bearish first act, just to show markets whose boss? totally unexpected and perhaps exactly what she wants

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Leftback
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October 14, 2013 at 1:40 PM ×

Maybe we do get a year-end melt-up. But doesn't that mean we have to have a mini-meltdown first?

So much of one's perception of markets depends on one's own vantage point. From where LB sits, the post-shutdown growth outlook for the US still looks like it will be piss weak, and the last few weeks have seen a rotation OUT of the momo stocks and into value and fixed income.

So... while we agree with TMM's overall thesis that there are still going to be players who are going to rotate out of bonds and into stocks, we don't think that happens here - not until we see yet another drop in yields that will take many by surprise.

As of Friday afternoon, markets were priced for no government shutdown, no short term bond market disruption risk, no slow growth surprise, no earnings disappointments and no FX volatility. That kind of combination of hope and complacency always makes us want to go short - and we did.

Btw, Pol, some British readers will be aware that the strength of US elastic is often over-estimated, and it can often give way rather easily.

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abee crombie
admin
October 14, 2013 at 2:22 PM ×

also, maybe its easier to have a view when you are a bit farther away but it seems consensus that the government wont do something boneheaded, I think the risk is very real. There is just so much animosity. Republicans vs Demos = german vs greeks. They live in different universes

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Leftback
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October 14, 2013 at 2:31 PM ×

Interesting that LB's former colleague Eugene Fama* won the Nobel Prize today for the Efficient Markets Hypothesis, one that is proved wrong almost every week by the markets - as documented right here on this blog. A more delicious irony would have been for him to win in 2008.

Still I suppose Fama is the Patron Saint of Vol Sellers, since in a true EMH world, the VIX would be zero ± the thermal noise in the algo boxes.

* LB once briefly held a janitorial position at the University of Chicago.

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Anonymous
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October 14, 2013 at 6:12 PM ×

I dont think any of the recent moves were really driven by fear of default risk. The tbill moves was all about money market funds making sure people dont fret, not a real belief that this was possible tail risk. Q4 and beyond are simply looking tepid for growth. A lot of the DOW move is post-rebalancing, where the index-add topticked some now overweight names.

Like TMM is saying there is no denying the flows into stocks from other asset classes and DM equities remain the only game in town.

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Anonymous
admin
October 15, 2013 at 2:55 PM ×

The Federal Reserve's new "tool"..The fixed-rate, full-allotment overnight reverse repo facility:

http://tinyurl.com/ko7oasj

http://www.newyorkfed.org/markets/rrp_faq.html

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