This was further evident in looking just at March: US equities rose by 3%, outperforming European equities by almost 4% (in dollar terms). Outperformance in the US markets is partly reflective of the differing underlying economic developments of the two regions.
The good (ish)…
Looking through recent data only confirms varying economic trends. Last week was always going to be a big week on the data front, with releases on manufacturing and activity data to labour data announced on both sides of the Atlantic.
In the US, the Institute of Supply Management Purchasing Managers Index (PMI) for manufacturing advanced, contrary to expectations. While favourable weather and seasonal conditions have no doubt helped to prop up momentum, forward looking indicators signal a low risk of a return to last summer’s tepid growth.
The labour data released last week, which disappointed even the most bearish of forecasts, reminded everyone that even the US recovery is going to be choppy, continuously requiring the helpful hand of super easy monetary policy.
While the unemployment rate fell to 8.2%, the US added only 120,000 non-farm jobs in March, the lowest level of monthly additions in five months. Caution is warranted against using this single data release as a basis for suddenly getting overly concerned that the U.S. recovery will relapse. Other labour data, such as initial jobless claims and the ADP employment report, indicate the gradual healing in the labour market is based upon more solid foundations.
However, after last week’s Federal Reserve Open Markets Committee’s minutes of its last meeting indicated the members had moved further away from a third programme of QE3, weak labour numbers led the market once again to realise that the Fed is nowhere near removing this large punch bowl just yet.
Despite the higher confidence in the US recovery, one should remain cautious of the downside risks. One of the primary concerns is that a sharp automatic fiscal tightening may occur following the November Presidential election, should there be no budget agreement by both parties in Congress. In aggregate, the automatic fiscal tightening could be as much as $700bn, or 4.6% of GDP. This would easily be the largest fiscal tightening in the past 50 years (the largest, 3.1% of GDP in 1969, helped trigger a recession in 1970).
The bad…
The size of this fiscal adjustment is comparable to that undertaken by Greece, for example. The majority of the fiscal adjustment is due to the expiration of the Bush and payroll tax cuts as well as cuts following last year’s debt ceiling deal. We should state that we do not expect such a considerable fiscal tightening.
Both parties are keen to avoid the automatic sequester so a year-end deal is likely. There appears to be cross-party agreement on extending the Bush tax cuts, so the most likely scenario is delaying the unwinding of the budget deficit.
However, last year’s budget fiasco highlights the importance of considering such a risk. This is especially crucial given that since the financial crisis, government fiscal transfers have been a huge support to the household sector, with government transfers now accounting for almost 18% of disposable income, compared to 14% in 2007.
With households set to receive less support from the government in the years ahead, the corporate sector is going to have to do a better job of increasing employment. If last week’s labour data is to be the start of a trend (not our expectation), the warm seasonal weather may encourage the bears to come out in full force.
The likely
So where does all that leave us in terms of strategy?
On the eve of what is likely to be a very pedestrian US first quarter earnings season, the slow recovery will again be emphasised in pressure on profit margins and slower top-line sales growth. After the rally of the past six months, investors clearly want to see evidence that growth dynamics have turned positive on a sustainable basis and at an acceptable pace. In other words, a self sustaining recovery at least under way in the private sector in the US, built around business spending and/or a revival in credit.
Important as the seeds of the recovery are, 2.5% growth in the real economy will not excite investors.
On a positive note, however, the reduced risk of a reversal of Fed policy, and in particular of an early end to the very low real interest rates across the yield curve, mean a deep correction is unwarranted at this point, absent a supply shock like a spike in oil prices.
In our view, equities at worst should be volatile and range trading for a period, with the high yield corporate debt sector prospering alongside quality and yield-oriented equities.
Watch the gold price for a clear steer as to whether another turn of money printing is coming our way before too long. Right now, the jury is still very much out over whether additional monetary printing will eventually happen.
