Investment Management Blog - Montague Capital

Let’s see if we’ve got this straight.  The idea of financial markets is that they are supposed to be efficient processors of all available information and anticipate where the trend is headed.  How then do we make sense of yesterday’s surge on Wall Street, and the slavish imitation of European equity markets, to news that US CY08Q2 GDP growth had been revised up from last month’s government estimate of 1.9% to a whopping 3.3%?  Being way better than the 2.7% figure the “analysts” had been expecting, it had to mean that there is going to be no recession, didn’t it?  Well, actually no, at least not yet.  Let’s not dwell too long on the cynical interpretation that Junior’s mob might have been clever enough to imitate the sneaky tactic beloved of embattled corporate CEOs.  “Low-ball” your forecasts and the market will love you when you beat them.  Let’s not even be that picky about whether US official statistics have a better track record for accuracy than the UK Office for National Statistics.  Rather let’s look at why the GDP number had been as good as it (apparently) has and ask if it can be sustained.  

The first component of the number latched onto gratefully by the bulls is US export growth.  A 13.2% annualised rate was much better than CY08Q1’s 9.2%, but it was apparently built upon the weakness of the US dollar and strong demand in export markets.  What has happened to the US dollar so far in CY08Q3 and where is the market now expecting it to go?  It has got, and is expected to continue to get, stronger.  What is happening to growth rates in economies to which the US exports?  They are slowing down.  What do these two factors taken together mean for potential US export growth going forward?  We foreigners have less spare cash to buy US exports even if the new-found strength of the US dollar had not sent their prices up.  Future export growth isn’t going to be as good.

Next, we are asked to believe that US consumption growth has been unexpectedly strong.  Well, that may, or may not, be true.  The conclusion sits at odds with survey data on retail sales, savings intentions and consumer sentiment.  But given what had been thrown at the problem in the way of income tax rebates, it would have been bitterly disappointing if there had been no positive effect at all.  Unfortunately for the bulls, there is no immediate prospect of another consumption-boosting tax cut any time soon.  Why should there be, if US Inc. is now on the path to economic recovery?

Finally, if recession really has been avoided and the US is back in growth mode, what is going to happen to monetary policy?  With the Fed funds rate at 2%, real US interest rates are -3.6%.  That’s not what you need if your economy really is growing at over 3% and has an inflation rate approaching 6%.  And when interest rates go up, what happens to consumption and housing?

Objectively and dispassionately, it seems wrong for markets to have reacted as they did.  The US may be further into its recession than Europe and Asia, but it still isn’t seeing the sort of recovery in housing, investment or credit that would flag the start of a meaningful recovery.  As for the UK and Europe, have dealers been paying no attention at all to publications from the Bank of England and the European Central Bank?  Get used to it: we are headed for recession.  Hanging on to yesterday’s gains is going to require more than just a dose of bullish hot air if the force of gravity is to be resisted.

  Look too at some of the micro data on US Inc. that emerged yesterday.  The retailer Sears saw FY08Q2 sales fall 4% and earnings fall 62%.  Perhaps it’s just the recipients of tax rebates shop more often at Sam’s Club than K-Mart?  Actually, they do, but the number still doesn’t increase confidence that the GDP data is flawless.  Computer maker Dell’s earnings for the same period fell 17%.  Greater use of “bricks and mortar” retail and an aggressive pricing policy (but have you tried pricing what a working Dell PC would cost, compared with the advertised “price”?) hit the gross margin hard, offsetting the positive effect of 11% sales volume growth.  But what is worrying is the company’s observation that recent dollar strength is now hurting sales, because of which it refused to issue “guidance” for either the current quarter or the full year.  What kind of “visibility” of earnings or expression of confidence in the future is that?  The Financial Times has calculated that Merrill Lynch’s credit crunch losses over the last eighteen months are now equivalent to about one-quarter of all the (inflation-adjusted) profits it has earned in its 36-year life as public company.  And the write-off game isn’t over yet.  No surprise then to learn that the Bank of China is so inspired by the quality of the US financial system that it has reduced its exposure to the “safe” and “guaranteed” paper issued by Fannie Mae and Freddie Mac by 25% in just the last two months.  If countries running huge trade surpluses decline to recycle that money by subsidising the US government and households, then the entire model is in serious trouble.  So much for sovereign wealth funds. 

For the second month in a row the CBI’s survey of the UK retail sector has resulted in a record low reading, with 46% of retailers reporting a y/y fall in sales.  One of the wettest Augusts on record didn’t help, but the CBI also puts a chunk of the blame in the slowdown in the housing market.  On which point, the Nationwide’s latest house price survey showed a 1.9% fall m/m, a 10.5% fall y/y and, for those with seriously masochistic tendencies, a 17% fall in the annualised q/q figure.  Those of a nervous disposition should under no circumstances read today’s Lex column in the FT.  This correctly identifies “ludicrous earlier valuations, a shift in buyer psychology, and credit withdrawal by lenders” as the causes of the collapse to date.  But which of these has now been laid to rest?  Finally, yesterday’s note commented on LibDem proposals to try to stabilise the housing market.  Hey presto – one day later and the package has rematerialised as official Labour Party policy.  What a bunch of spineless wasters!  Can’t they generate new ideas on their own?