Sentinel News

Market Insights: November 2012

Overcoming the Brake Light Shockwave

There are fewer big themes in the world these days. Big democratic breakthroughs, say Egypt, Tunisia are halting and fall far short of the hopes they embodied. Technology is a race over mobility and brevity but hardly elicits the same wonder from years past. Governments are polarized. The US had almost no voting overlap in recent years so big ideas are on the wane. In Europe, the supra-national organizations like the EU are swift to talk and slow to act. No we're not reactionaries. We think all this is explained by the deepest drop in output in the post-war period and the slowest recovery. In the US, the recession officially ended in June 2009 but unemployment at 7.9% is nearly double the pre-crisis levels. Throughout all this, "uncertainty" is the order of the day. Uncertainty over employment, demand, fiscal cliffs, European harmony, monetary policy and, above all, recovery. These are themes that have been with us even before 2008. The stock market remains below its 2000 peak; investors have had a rough dozen years. Investing patterns continue to be a series of short, sharp moves. This may not end for a while. Here's why.

The European crisis started in Greece. While the headlines have shifted to Spain and Italy and other peripherals, the problem remains unsolved. When Greece first surfaced in 2010, reform programs, a few write-downs and transfer of debt to the ECB[1] were meant to do the trick. Far from it. The latest target had Greece's sovereign debt dropping to 120% in 2020 from 170% currently. But it is now expected to increase to 180% next year or around $451bn on a $250bn economy. To meet the longer term target of 60%, there are two broad approaches:

  1. Austerity Shrinkage: which is the pattern of the last five years and would require the Greek economy and debt to shrink by 5% and 10%, respectively. That would result in a disastrous decline in living standards. This achieves the 60% target in 2032. Or...
  2. Austerity Growth: where Greece could grow 5% a year and shrink debt by the same amount. This requires a growth rate five times the European average in a world economy growing even less and a willing suspension of economic reality. This achieves the target in 2024.

There are a couple of other options, namely partial default and euro withdrawal. But neither of these is on any political agenda. Despite many advocates for Greece to revert to the drachma, we have seen in recent months an overwhelming commitment to keep the union intact. This was most publicly explained in the headline speech of Mario Draghi in his "whatever it takes" moment in July but has been a motif for months. So the solution will surely be to maintain the pressure on the Greeks, eke out economic recovery, push aid in installments and, above all, keep talking.

"Verbal Intervention"
Elsewhere in Europe, the most effective policy has been, as Trend Macro puts it, "verbal intervention." In the last three months, we had i) a Spanish bank bailout which appeased the markets but required no actual money transfer or guarantee ii) the pre-announced but much delayed birth of the European Stability Mechanism, a funding program without funds iii) the "whatever it takes" speech with no follow-up intervention and iv) the Outright Monetary Transactions without any, well, transactions. At the time, we thought the market would challenge such bluster with a series of raids on sovereign fixed income markets. But it hasn't happened. Yields have come in, spreads steepened, credit default swaps cheapened and stock markets stabilized. So something has kept the markets in check. What is it?

We think the following:

Cometh the Hour: Draghi has shown a deft hand at managing the euro constituents. The tough money crowd over at the Bundesbank has charged him with i) breaking his constitutional mandate by buying bonds of troubled countries, ii) a weakening commitment to inflation, and iii) a susceptibility to political interference. But he has been very consistent on the need for banking reform and oversight, requiring conditions for any access to bailout funds and keeping the 2% inflation target front and center of any policy revamps.

A few weeks ago he spelt all this out to the German Bundestag where he assured all that, no, the ECB would not finance governments (so no monetization), nor compromise central bank independence (so no political pressure), nor create taxpayer risk (so no increased taxes), nor create inflation (the German nightmare). He has now positioned the ECB to continue policy at a time when banks seem unwilling to pass on monetary stimulus to the real economy. For sheer management of competing constituencies, the man deserves a medal. And for now, the ECB is the only game in town and the major authority figure.

Lull in the Storm: Recent stats on the euro economy are pretty dreadful. Private and government consumption falling, unemployment at over 10%, exports down and investment up against a real decline in sentiment. Add on the lack of bank reform, slowing of monetary aggregates and lending, various noises off on euro withdrawal from the weak (Greece) or the strong (Finland), and it looks like things could flare up very quickly.

But they probably won't. We should never underestimate the political will to maintain the European Union. In general the post-war themes in Europe have been for countries to be less authoritarian, less narrow, more international and slowly deposing themselves from old positions of dominance. This continues today. Europe is not particularly dependant on the US (exports to the US are around 3.5% of GDP); it runs a current account surplus (which explains why € bears are consistently wrong); and it heeds little to China's exchange rate. Thus we see, yes, protracted distress but no crash.

So for the next few months, Europe will continue to infuriate policy didacts but will probably stabilize. It's a question of many headlines and drama but no big breakthrough. Another point to watch is that as the German economy slows, its opposition to growth policies will wane. Starting with its own.

US: Overcoming the Brake Light Shockwave
There's a behavior familiar to all drivers called the "brake-light shockwave." A flash of brakes on a highway creates a wave of braking, causing traffic five miles back to grind to a standstill. Much of the tale of the US economy over the last few years can be seen in this way. As soon as we get any momentum, European worries, fiscal drag, global slowdown, or any negative headlines cause everything to slow down. Since the middle of 2009, we have had two quarters of growth of 4%. All others have barely made it over 2%. The latest GDP and personal income figures tell much of the story:

  • government has been a net drag on growth for nine out of the last eleven quarters;
  • state and local government had a negative contribution to growth for twelve straight quarters;
  • private fixed investments have slowed considerably but...
  • residential investment has gradually increased; and
  • exports, which contributed nearly half a point of growth for three years, turned negative.

Now, first estimates for any quarterly GDP change are a bit dicey. The swing between initial estimates and final numbers has been between 0.2% to over 1.0% in the last two years. But the story behind these numbers is that i) nominal GDP was up 4.9%, the fastest rate in twelve months, which is critical for revenues ii) government defense spending jumped 13%, that hardly looks sustainable but meant iii) government was a contributor to growth for the first time in nine quarters iv) businesses pulled back on investment and inventories, which is no surprise as the Fed regional reports were telling us that for months and v) personal consumption grew at around 2.0%, which was no change on the year. It's probably not enough to dent unemployment. And that's because...

The consumer is barely making it. Here's a chart showing no real change in disposable income per capita, stuck at around $32,700 and dipping last quarter, and the saving rate, which fell to 3.7% and explains some of the increase in personal consumption.

Source: Federal Reserve Bank of St. Louis, Economic Research

There's a limit to how much households will dip into personal savings especially as nominal incomes rose only 0.4% and real incomes were flat, after declining in August. So there's not much to expect from the consumer which explains this:

Source: Federal Reserve Bank of St. Louis, Economic Research

Which is the Fed's favorite inflation measure, the broad based personal consumption expenditures price index, at well below its 2% target. It's currently 1.7%. An even broader measure of inflation, here the CPI[2] less food and energy, looks pretty tame:

Source: Federal Reserve Bank of St. Louis, Economic Research

Consumption is held back by very low wage gains, falling income from assets and probably some very listless behavior in anticipation of taxes increasing in January. All this would be pointing to recession but for this, which shows housing on an improving trend.

Source: Federal Reserve Bank of St. Louis, Economic Research

Housing and residential investment account for around 20% of personal consumption which in turn accounted for 70% of GDP a year ago and 74% now. It's definitely a good sign. Lower mortgage rates, cheaper own to rent ratios, higher shadow and real inventories and increased housing starts are all beginning to have their effect. But it's not enough to propel GDP growth into 2% or lower levels of unemployment. And GDP per head growth is still only around 1.5%.

Steady at the Fed
September's Fed meeting may well go down in history as this was the first time that specific economic targets were attached to policy goals. This should eliminate some of the doubt that the Fed had the stomach to continue asset buying beyond a quantitative level and addresses the question that many had when the Fed put forward the notion of holding rates down until 2013. Because the obvious question was "and then what?" We think one of the charts the Fed looks at is this:

It shows the federal deficits (blue line) decreasing, by around 0.5% of GDP, yet rates staying low. This can only be an example of low demand and contraction. So they have put every possible policy forward to stem the impact of austerity. And especially now that the New Year is likely to bring further fiscal contraction. Ideally, the Fed chairman would like coordination of the monetary and fiscal authorities: the Fed keeps rates low, the government borrows into the stream of low rates, restores its finances, stops any risk of deflation and fills some of the demand gap. So far, the fiscal side has not responded. It's a one-sided game of tennis which explains the general market doldrums.

Capital Markets
Earnings outlooks are very uncertain. One feature of the past reporting season was the miss on top line growth. This should have been no surprise. The rollover in nominal GDP in the US, weak exports and European markets and the marginally weaker dollar all meant the average sales surprise was down 0.3% and earnings up 4% (they're normally up by 6% which is a result of guidance management and the odd sub-industry of street analysts consistently marking lower than actuals). The market has also leveled off since the Fed meeting. The diminishing effect of the QE announcement is shown when we look at QE1 in early 2009 and QE2 in late 2010. Back then 90% of S&P[3] companies rose above their 200 day moving average within three months. Today only 60% of stocks have managed that.

What we continue to like in equities, however, is the level of real yields. Back in March of this year, the forward yield on stocks dipped to 2.1% compared to 10-year treasuries at 2.0%. Today that number is 2.4% on the S&P and 1.75% on the note.

So put all this together:
  1. Europe may be bottoming for bad macro news and...
  2. European equities start to look attractive.
  3. The rest of the year in the US will be economic news dominated by employment and...
  4. The debate on the fiscal revenue/spending trade-off with...
  5. Another grueling debt ceiling round in the New Year.
  6. Most assets will sit in a range, 1350 to 1450 on the S&P, and
  7. 1.6% and 1.9% in the 10-year note.
  8. Valuations on risk assets are still attractive, so we remain overweight equities and IG[4].

Sources: Rory Sutherland, The Spectator; US Department of Commerce; Trend Macro; Tim Duy's Fed Watch; VOX EU; Bureau of Economic Analysis; US Department of Commerce; Bureau of Labor Statistics; Capital Economics; Der Spiegel; Federal Reserve Bank of St. Louis; High Frequency Economics; Bloomberg;; David Henderson, Innocence and Design: The Influence of Economic Ideas on Policy; Sentinel Asset Management, Inc.

[1] European Central Bank
[2] Consumer Price Index
[3] Standard & Poor's 500 Index is an unmanaged index of 500 widely held US equity securities chosen for market size, liquidity, and industry group representation. An investment cannot be made directly in an index.
[4] investment grade (bonds)




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