“Perpetual optimism is a force multiplier.”
Politicians have been trying to spin multiplication theories for generations. From time to time, within their own groupthink tanks, these theories have become particularly influential – especially with the large percentage of the political-class that doesn’t do math.
In 1936, when he wrote the General Theory, John Maynard Keynes focused on what he infamously coined “The Multiplier Effect.” The theory was that every dollar spent by government would have a multiplier effect (greater than 1) rippling throughout the economy. Unfortunately, when Keynesian governments tried that in the late 1920s it didn’t work – and it hasn’t worked since.
Despite being proved wrong throughout the 1 period, Keynes, ever the master Storyteller, found a way to re-frame his vision of the elixir of a government-stimulated life. Keynes preached “that it is a complete mistake to believe that there is a dilemma between schemes for increasing employment and schemes for balancing the budget.” (Keynes Hayek, page 135)
What does 1 scheme multiplied by 2 more failed schemes equal? But these guys have to do something!
Fortunately, President Bill Clinton figured this out and wanted nothing to do with being labeled a Keynesian. President Clinton, like President Reagan, oversaw one of the 2 largest decades of employment growth in US history (by decade, the 1980s and 1990s saw between 18-22 million jobs added (net), respectively – Obama/Bush decade = net zero).
And Clinton did it with a balanced budget mandate…
Fact Check: Clinton’s Balanced Budget Act of 1997 led to the following Federal Budget results:
- 1998 = +$69B surplus
- 1999 = +$124B surplus
- 2000 = +$230B surplus
“… the first surplus in three consecutive years since 1, when Harry Truman was President. The debt had been reduced by $360B in three years with $223B paid in 2000, the largest one-year debt reduction in American history.” (Keynes Hayek, page 274-275)
I’m not a Republican or a Democrat. I’m just a man who wants to get this right. And, setting aside all of the other angles on this Presidential Election, I think that if Obama or Romney get the economic policy messaging right, they’ll win the election.
So far, President Obama has a lot of Reagan in his economic policy legacy (ballooning national debt balance and Keynesian spending). Romney’s got plenty of baggage too, but maybe he has a bigger opportunity to be the change Americans want to see in our economics.
Last night on The Kudlow Report, Larry asked me what I’d suggest Romney be (economically). My answer: ½ Clinton ½ Reagan.
Back to the Global Macro Grind…
I’m coming into this morning’s US market open hot. I don’t mean Alabama Crimson Tide hot – I mean locked and loaded with the most Global Equity exposure I’ve had in well over a year:
- Long US Consumer Discretionary(XLY)
- Long US Consumer Staples (XLP)
- Long US Utilities (XLU)
- Long Chinese Equities (CAF)
- Long Hong Kong Equities (EWH)
But how hot is hot? Well, get out the calculators and tell me what your money is up or down if you sold all of your Asian and US Equity exposure between February and April of last year, and you tell me.
We all invest from the vantage point of what’s in our own accounts. This cochamamy storytelling of the Old Wall that there is an optimal “asset allocation” is as broken as Keynes personal accounts were when they crashed in 1929.
Money compounds. Anyone who does math with their own money gets that. Money also gets evaporated during big draw-downs (i.e. if you’re still long SP from October 2007, you’re still down -18.2% from there and need to be up over +22% to get back to breakeven). That’s math too – it’s called geometric.
For my money, moving to a 24% total Global Equity asset allocation in an environment like this actually makes me really nervous. Maybe that’s why it’s working for 2012 YTD (Chinese Equities are already up +3.9% for the year). Maybe it’s not. All I know is that what I don’t know is what makes me nervous about being long anything tied to government decision making.
Maybe Powell was right about the force-multiplier of optimism. Maybe I’ve been right on the trust-divider of fear-mongering. All I know is that, combined with a Strong Dollar, the best of ½ Clinton ½ Reagan is a winner for me.
My immediate-term support and resistance levels for Gold, Oil (Brent), EUR/USD, US Dollar Index, Shanghai Composite, and the SP500 are now $1, $111.89-115.61, $1.26-1.29, $80.41-81.61, 2178-2295, and 1, respectively.
Best of luck out there today,
Keith R. McCullough
Chief Executive Officer
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Conclusion: Hong Kong looks ripe for a bullish trade.
Position: Long Hong Kong equities (EWH).
Down -17% from when turned outwardly bearish on the Hang Seng, we are well aware of the bear case for Hong Kong. That puts us a unique position to have an educated view on the catalysts that could get this thing turned around – specifically on the growth/inflation front.
The immediate-term catalyst calendar looks favorable (views based on our models and global macro outlook):
- JAN 10: DEC Chinese exports should continue to slow and lower expectations for the following week’s growth data;
- JAN 11: DEC Chinese CPI and PPI should show continued disinflation and create incremental room for China to ease monetary policy;
- JAN 16: DEC Chinese industrial production, retail sales, fixed assets investment data and 4Q11 real GDP should all slow at a slower rate and may even surprise depressed consensus estimates to the upside;
- JAN 19: Hong Kong unemployment rate should continue to back up, though only marginally;
- JAN 20: Hong Kong CPI should continue to slow on the strength of King Dollar’s increase in purchasing power, which the Hong Kong dollar is pegged to; and
- JAN 26: Hong Kong exports should continue to slow at a slower rate and on a lag to a pickup in manufacturing.
From an intermediate-term perspective, buying the EWH with the Hang Seng less than -0.3% shy of our TREND line of resistance does indeed suggest we believe in the index’s ability to break out above the TREND line on the strength of the aforementioned macro calendar. As Chinese and U.S. economic growth bottoms in 1Q12 (China = 52.7% of Hong Kong’s export demand; the U.S. = 11%), we look for Hong Kong manufacturing and shipping orders to accelerate ahead of reaccelerating end demand in the coming months. To that tune, manufacturing slowed at a slower rate in DEC, with the PMI reading ticking up to 49.7 vs. 48.7.
Growth slowing at a slower rate is a leading indicator for a reacceleration in growth.
Conclusion: India screens flat-out awful on all of our fundamental and quantitative factors. As such, we remain bearish on Indian equities and the Indian rupee over the intermediate-term TREND.
Virtual Portfolio Position: Short Indian equities (INP).
From a quantitative perspective, Indian equities look awful. From a fundamental perspective, India’s economy looks just as dire. While neither point is new news to Hedgeye clients, we have taken advantage of the latest price action in Asia to hedge our long Chinese equities position with one of our least favorite international stories (equities, debt, and FX) for the better part of the past 14 months.
As a refresher, our updated views on India are as follows:
Growth: Indian real GDP growth continues to slow and looks to sink to bombed-out levels in 1Q12, where we’re modeling in a range of +6-6.5% YoY based on all the data and quantitative signals we currently have at our fingertips. Those estimates are subject to further downward revisions pending more 4Q high-frequency data.
Inflation: Inflation remains the largest headwind for the Indian economy and corrosive to the real returns of holders of Indian assets. Just like in late 2010, the Reserve Bank of India is again guiding consensus expectations to an intermediate-term inflation target that we don’t think they’ll achieve (+7% YoY by MAR from +9.1% in NOV). To that tune, while slowing, our models can’t get below +7.8% on YoY WPI over the intermediate term, as Indian inflation continues to be fueled by sticky energy costs, rather than slowing food and primary articles inflation. Further, Brent crude oil remains in a Bullish Formation amid heightened geopolitical risk. Net-net, the RBI will be forced to continue largely sitting on its hands as elevated inflation continues to narrow the scope of using monetary policy to support economic growth.
Policy: Speaking of policy, economic and political leadership in India remains among the worst (w/ Argentina and Russia), if not the worst, of any of the G20 economies. We’ve been all over their ineptitude over the past year (FEB ’11: India – Missing Where It Matters Most and MAY ’11: India’s Nasty Trifecta) and continue to see little in the way of positive momentum.
Subir Gokarn, deputy governor of the Reserve Bank of India, said last week that “the monetary cycle has peaked.” While not at all a surprise, we do think his additional commentary confirms our view that the RBI is in a box as it relates to monetary policy. More specifically, India’s growth/inflation dynamics prevent them from raising or lowering interest rates – a condition that is usually a leading indicator for “creative” central banking and misguided capital account policy changes in emerging markets:
“The RBI is very concerned about the impact of rupee depreciation on inflation… The central bank remains more comfortable using open-market operations to inject liquidity for now, because cutting the cash reserve ratio would send a premature signal that the monetary policy stance has changed.”
-Subir Gokarn, 1/5/12
To that tune, Indian banks are taking advantage of RBI liquidity at an accelerating rate in the face of ever-tighter interbank lending conditions, borrowing an average of $22 billion a day from the central bank in DEC (up from $17.5 billion in NOV). We remain the bears on the Indian rupee, which has fallen nearly -16% vs. the USD from its cycle peak in early AUG. We look for King Dollar’s breakout vs. the INR to keep an elevated floor under the dollar-denominated debt servicing costs of Indian corporations and their ability to refinance – dramatically eroding what little earnings growth is left on the table. Per the latest data, India’s corporate bond issuance dropped to 14-quarter low of 257 billion rupees in 4Q12 (through mid-DEC).
On the fiscal front, India’s widening federal budget deficit and resultant increase in sovereign debt supply continues to provide an overhang on Indian growth and the nation’s currency, as well as a floor under interest rates absent RBI intervention in the secondary market (the RBI has purchased just under 500 billion in sovereign debt since NOV). As Indian banks are forced to underwrite incremental sovereign debt supply amid a -97% miss in the FY11 state asset sales target of 400 billion rupees and a big miss in tax revenue stemming from a pollyannaish +9.25% FY11 growth target, interbank liquidity is eroded (see previous chart).
As a result of India’s Finance Ministry being way off on its economic growth assumptions, the country is all but assured of missing its 4.5% budget deficit target, contributing to a crowding out of private sector credit growth. That may ultimately spark a wave of defaults across the lower end of the country’s credit spectrum.
To that tune, the RBI released a report on 12/22 that forecasted India’s aggregate NPL ratio could climb +300bps to 5.8% by March 2013 in a “stressed macroeconomic scenario”. We’re not sure what they define as “stressed” but their history of underestimating the downside in growth and the upside in inflation suggests to me that their worst-case scenario may ultimately be closer to baseline when it is all said and done. With elevated mortgage rates (16.5%), slowing property sales (-20% YoY in Mumbai in NOV), and eroding earnings growth (-23% YoY in 3Q11), Indian property developers may pose a serious risk to the balance sheets of Indian financial institutions with 1.8 trillion rupees in debt coming due over the next 3yrs.
This dire scenario is being reflected in the 5yr CDS of the State Bank of India, which at 405bps wide, is challenging post-Lehman levels of stress.
Jumping ship to regulatory policy, India has recently hit rock-bottom in this regard. India’s lawmaking body passed just 22 laws in 2011 (the second-lowest since 1952) amid several notable corruption scandals that fueled political gridlock, a well-publicized renege on pro-growth retail market reform, and a monumental failure to pass Prime Minister Singh’s anti-corruption Lokpal bill at year’s-end.
Turning to what’s coming down the pike, India will have five regional elections next year, and reading through from the macroeconomic malaise, Singh’s Congress party stands to lose incremental support in parliament over the intermediate term, which may perpetuate gridlock. India’s inability to get it done on the regulatory front forces us to remain skeptical that they’ll be able successfully reform the country’s convoluted tax code – a key “win” needed to reign in the federal budget deficit. For example, India’s government revenue as a % of GDP is only 18%, which compares to 21%, 36%, and 37% in China, Brazil, and Russia, respectively. Moreover, India’s lawmaking ineptitude and de facto green light for corruption suggests to us that they’ll are likely to fail to capitalize on a planned $1 trillion in infrastructure spending over the next 5yrs. Time will ultimately tell here, but if their past behavior is any indication, India will have limited success in this regard.
All told, India screens flat-out awful on all of our fundamental and quantitative factors. As such, we remain bearish on Indian equities and the Indian rupee over the intermediate-term TREND.
Positions in Europe: Covered France (EWQ) today in the Hedgeye Virtual Portfolio
Below are key European banking risk monitors, which are included as part of Josh Steiner and the Financial team's "Monday Morning Risk Monitor".
Euribor-OIS spread – The Euribor-OIS spread (the difference between the euro interbank lending rate and overnight indexed swaps) measures bank counterparty risk in the Eurozone. The OIS is analogous to the effective Fed Funds rate in the United States. Banks lending at the OIS do not swap principal, so counterparty risk in the OIS is minimal. By contrast, the Euribor rate is the rate offered for unsecured interbank lending. Thus, the spread between the two isolates counterparty risk. The Euribor-OIS spread tightened by 4 bps to 94 bps w/w.
ECB Liquidity Recourse to the Deposit Facility – The ECB Liquidity Recourse to the Deposit Facility measures banks’ overnight deposits with the ECB. The ECB pays lower rates than the market, so an increase in this metric demonstrates increased perceived counterparty risk and liquidity hoarding. Over the course of the last few months, this metric has been making higher highs and higher lows, a pattern that continued last week.
European Financials CDS Monitor – Bank swaps were wider in Europe last week for 29 of the 40 reference entities. The average widening was 2.5% and the median widening was 7.2%.
Security Market Program – The ECB's secondary sovereign bond purchasing program bought €1.104 Billion in the week ended 1/6 versus no reported buying in the week ended 12/30 and €3.361 Billion in the week ended 12/23 to take the total program to €213.0 Billion.
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