Is the correction over?

The recent bout of volatility in the capital markets owes much to the turmoil seen in the emerging markets. Both emerging market bonds and equities have recently been hammered on the basis of:

• Slower growth in China; and
• The whispers of Fed "tapering", which caused an unwind of the risk trade in EM bond and equities.

By the end of the week, it appeared that the storm that was battering the markets was abating. Breadth indicators had reached oversold levels and fear levels were starting to recede. Consider this chart of the NYSE New highs - New lows, which fell to levels consistent with the end of past minor corrections and saw a bounce late in the week.

Bill Luby at VIX and More suggested watching DBV, the currency carry trade ETF, as a measure of risk appetite. Look at the five year weekly chart, DBV fell to the bottom of its Bollinger Band, which is an indication of an oversold condition, and mean reverted late in the week. Such mean reversion rallies from oversold are classic buy signals.

The question then becomes one of whether this is just a minor correction of the start of a bigger bearish impulse in stock prices. As I mentioned earlier, the fear of Fed tapering threw a scare into emerging markets, largely because the QE promise of cheap money pushed a lot of "hot money" into EM and the prospect of an unwinding caused the "hot money" to rush for the exits.

The carnage is particularly acute in emerging market equities. The chart below shows the relative performance of emerging market stocks (EEM) to the MSCI All-Country World Index (ACWI). This longer term chart back to 2008 looks rather ugly. EM equities staged a relative rally in the wake of the Lehman Crisis but topped out in 2010 and they have been underperforming global equities ever since. Earlier this year, EEM broken an important relative support level against ACWI and has been plunging ever since. From a technical viewpoint, there is no bottom in sight.

Emerging market bonds, however, tell a different story. I wrote last week that I was worried about the signal from the EM bond market and to watch the relative performance of EM bonds relative to US high yield market for signs of a break (see The bear case for equities). Lo and behold, EM bond prices recovered strongly late in the week, not only against US high yield, but against 7-10 year Treasuries:

At a crossroads: The Fed, China and earnings
Which is giving us a better signal? EM bonds or equities?

My trader's instincts tell me that, in all likelihood, that the correction is over. The market saw oversold conditions on a number of indicators and the VIX Index hit levels that saw the end of past corrections. The key "tell" were the reversals in these short-term indicators

On the other hand, nagging doubts remain as the sources of volatility are still intact. First and foremost, the prospects of Fed tapering has heightened market volatility? Tim Duy believes that the September FOMC meeting is the most likely point at which the Fed announces that it would start to pull back on QE and his view is becoming the consensus one. He pointed to the likely trajectory of the unemployment rate as one of the key triggers of when the Fed would start to pull back.

On the other hand, Benn Steil and Dinah Walker indicated how difficult it is for the Fed to project unemployment rates by showing how the forecasts have changed over time and the likely effects on the timing of a change in policy.

Moreover, another debt ceiling fight is looming in September. The Hill reports:

A drawn-out debt ceiling fight in Congress could undermine the jobs growth that is expected later this year.

Economists argue that the nation's economic expansion is poised to accelerate in the fall once it weathers the headwinds of tax hikes and spending cuts.

While I recognize that any Fed action is highly "data dependent", would the FOMC move in the face of such fiscal uncertainties?

In all likelihood, Fed will probably calm market expectations about "tapering" in their FOMC statement on Wednesday, as signaled by the Jon Hilsenrath article. Nevertheless, sources of volatility remain as the markets are still highly jittery. Bloomberg reports that regardless of what the Fed has or hasn't done, it has managed expectations to such an extent that it has de facto tightened. Just look at the expectations for Fed Funds rates:

China and the EM contagion effect
In addition, the markets will stay jittery as signs of softness in China emerge, which they have as shown by Ed Yardeni's analysis:

The signals from commodity markets, a key indirect forward looking indicator of Chinese growth, have been mixed. While some key commodities like crude oil have seen prices stabilize and possibly stage upside breakouts...

On the whole, the entire commodity complex remains weak and the downtrend in prices remain intact.

The latest bout of turmoil in emerging market bonds and equities represent a cautionary tale for investors. If the mere whiff of Fed tapering of its QE program is throwing the EM capital markets into a tizzy, what happens if China hard lands if it is unable to successfully navigate its transition from a capital intensive economy to a consumer based economy? The World Bank recently issued a warning on the risks to the Chinese economy (via the BBC):

"The main risk related to China remains the possibility that high investment rates prove unsustainable, provoking a disorderly unwinding and sharp economic slowdown," it warned.

It further added that "should investments prove unprofitable, the servicing of existing loans could become problematic - potentially sparking a sharp uptick in non-performing loans that could require state intervention".

In addition, Fitch has warned that China credit bubble [is] unprecedented in modern world history:

The agency said the scale of credit was so extreme that the country would find it very hard to grow its way out of the excesses as in past episodes, implying tougher times ahead.

"The credit-driven growth model is clearly falling apart. This could feed into a massive over-capacity problem, and potentially into a Japanese-style deflation," said Charlene Chu, the agency's senior director in Beijing.

"There is no transparency in the shadow banking system, and systemic risk is rising. We have no idea who the borrowers are, who the lenders are, and what the quality of assets is, and this undermines signalling," she told The Daily Telegraph.

If China were to slow dramatically, what about the contagion effect? While many global banks can claim that they have little or no direct exposure to China and its shadow banking system, which is a likely source of downside volatility, can the same banks say that they won't be exposed if a Chinese slowdown affects the risk premiums in EM bond and equities? Would these same global banks have the same level of minimal exposure to other EM markets like Poland, Turkey, India, Brazil, Malaysia and Indonesia (just to name a few?)

Sam Ro at Business Insider highlighted a Morgan Stanley research report that showed the history of past EM crises:

 He went out to show the effects of the contagion effect on these markets [my emphasis]:

"Most shocks that have created sudden stops in the last 30 years have not been big enough to engulf all of EM, nor did they affect systematically important countries first," write the analysts. "Rather, it was the combination of a shock to a vulnerable economy and contagion that spread the shock to other economies sharing a common characteristic with the economy at the epicenter of the shock."

What about earnings?
As well, the outlook for US equity earnings estimates is a source of uncertainty. Ed Yardeni recently showed that Street estimates for revenues have ticked down, which is bearish:

On the other hand, earnings estimates continue to rise:

Can this be right? The top line estimates are falling but the bottom line estimates are rising? Margins would have to improve. By contrast to Yardeni's analysis, Thomson-Reuters showed that Q2 earnings guidance is the most negative on record:

Most of the negative guidance has been concentrated in the Healthcard, Consumer Discretionary and Technology sectors. We can interpret these readings in one of two ways. The most obvious is, "Wow! Earnings are going to be ugly and stocks are going to get hammered." The more nuanced take is that companies are guiding down expectations so that they can beat Street estimates, so most of the bad news is out already.

I have no idea which is the correct way of interpreting the deluge of negative guidance. Add in the uncertainty of the effects of sequestration, the wobbles last week in consumer confidence offset by the positive surprise in retail sales, you have the ingredients for more uncertainty and volatility.


Correction over?
Is the correction over? I honestly don't know. Last Monday, my Trend Model moved from a "risk-on" reading to "neutral", but my level of confidence in its forecast has fallen because macro uncertainty has risen substantially. We are at a crossroads in terms of market direction. My best forecast is that volatility is likely to continue.




Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

Two view of income inequality

Recently, I have seen a number of blog posts and articles about the uneven nature of the US economic recovery. Zero Hedge documents how the number of households on food stamps have climbed to a new record.

Over at FT Alphaville, Cardiff Garcia has pointed out that most of benefits of the post-Lehman Crisis recovery have accrued to the wealthy.

You can see the disparity in the consumer confidence figures by breaking them down by income levels.

My inner investor is horrified by these statistics. He could go on and start railing about how rising income inequality will ultimate create social pressures, which will ultimately damage the social fabric of the nation and be very bearish for the US in the long run. As an illustration of this trend, the chart below shows corporate profits as a percentage of GDP (in blue), employee compensation as a percentage of GDP (in red) and the US Gini coefficient, which is a measure of inequality (in green).

Classic economic theory holds that the three factors of production are capital, labor and rents. As the above chart shows, the returns to capital (profitability) has been rising while returns to labor (compensation) has been falling for several decades. Moreover, a rising Gini coefficient indicates that income inequality has been rising. At some point, this will create social pressures that has the potential to tear society apart. The American Dream is about equality of opportunity, not equality of wealth. Any steps that erode the equality of opportunity erodes American competitiveness (see my previous post Another American step to Argentina).

My inner trader is more agnostic. He shrugs and tells my inner investor that these problems have a way of not mattering until they matter. The income inequality situation is exemplified by the Tiffany vs. Wal Mart pair*. As the 10-year chart of the pair shows, the TIF/WMT ratio is rising and is not at an extreme yet and it is exhibiting positive momentum. In fact, my inner trader is more inclined to go long this pair with an eye to the upper end of the band as a target.

The Great Gatsby lives!






* I am being metaphorical. I would not actually trade this pair as a way of playing the income inequality macro trade, as there are highly company specific issues that can affect both TIF and WMT.



Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

Mystery chart leads to FX mystery

Further to my post Friday night (Would you short this?) From reading the comments, I can see that a lot of my readers got it. The chart is the AUDCAD currency cross. While this currency pair shows the Australian Dollar to be vulnerable to its Canadian cousin, the loonie, it brings up another mystery.

First of all, the pair may not be as technically vulnerable as it initially appeared because it hit a 50% retracement level on Friday despite breaking down from major multi-year support.

I understand how the hedge fund community seems to have piled into the AUDUSD short as the Aussie Dollar has gone into freefall for the last few weeks. The short position has been highly profitable in a very short time.

Here's the head scratcher. Why isn't its Canadian cousin similarly weak against the USD? The structure of the Australian and Canadian economies are very similar as they are both resource based and both about the same size.

Admittedly, Canada did see some surprisingly positive economic releases last Thursday (Ivey PMI) and Friday (employment). On the other hand, how long will it be before all the Aussie shorts pile into a loonie short position as an alternative, especially when the CADUSD remains in a long-term downtrend and it hit a Fibonacci retracement level Friday and backed off? For reference, see these bearish posts on the Canadian Dollar from Sober Look (Canada's latest job report is a mixed blessing) and FT Alphaville (Canada’s grizzly outlook).

Just asking.




Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

The bear case for equities

I have been fairly bullish in these pages and I remain cautiously bullish today. However, successful investors and traders look at the other side of the coin to see what could go wrong with their thesis. Today, I write about the bear case, or what's keeping me up at night.


The signal from emerging market bonds
James Carville, former advisor to Bill Clinton, famously said that he wanted to be reincarnated as the bond market so that he could intimidate everyone. The message from the bond market is potentially worrying. In particular, emerging market bonds are selling off big time. The chart below of the emerging market bond ETF (EMB) against the 7-10 year Treasury ETF tells the story. The EMB/IEF ratio broke an important relative support level, with little signs of any further support below the break.

Technical breaks like these are sometime precursors of a catastrophic event, much like how the crisis in Thailand led to the Asian Crisis. For now, the concerns are somewhat "contained". Yes, junk bond yileds have spiked...

On the other hand, the relative performance of high yield, or junk, bonds against 7-10 year Treasuries remain in a relative uptrend, which indicates that the trouble remains isolated in emerging markets.

Here is the relative performance of emerging market bonds against junk bonds. They have been in a multi-year trading range. Should this ratio break to the downside, it would be an indication that something is seriously wrong in EM that smart investors would be well advised to sit up and take notice of.

For now, this is just something to watch.


Are European stocks keeling over?
The second area of concern is Europe. Despite my bullish call on Europe (see Europe healing?) European stocks have been performing poorly in this correction. As the chart below of the STOXX 600 shows, the index has fallen below its 50 day moving average, though the 200 day moving average has been a source of support in the past.

The 200 dma is my line in the sand.



Faltering sales and earnings momentum
In the US, high frequency macro indicators are showing a pattern of more misses than beats, as measured by the Citigroup Economic Surprise Index.

Ultimately, a declining macro outlook will feed into Street sales and earnings expectations for the stock market. Ed Yardeni documented the close correlation between the Purchasing Managers Index against revenue estimates.

Viewed in this context, the PMI "miss" last week is especially worrying. Indeed, Yardeni showed that the Street's forward 52-week revenue estimates are now ticking down. Unless margins were to expand, which is unlikely, earning estimates will follow a downward path and provide a headwind for equity prices.

As Zero Hedge aptly puts it, this is what you would believe if you were buying stocks right now:

My take is that the downturn in high frequency economic releases a concern, but it is something to watch and it's not quite time to hit the panic button yet. I agree with New deal democrat in his weekly review [emphasis added]:

After several weeks of more positive signs, last week we returned to the pattern of gradual deterioration that began in February. This week most indicators remain positive and there were fewer negatives...

Last week I said that for me to be sold that the data is actually rolling over, I would want to see a sustained increase in jobless claims and a sustained deterioration in consumer spending. That wasn't happening as of last week, and it certainly didn't happen this week either. The economy still seems to be moving forward - but in first gear.

In summary, most of these concerns are on the "something to watch" list to see if any of these risks turn out to be more serious. My base case, for now, is that the market is undergoing a typical rolling correction, with leadership shifting from interest sensitive issues to deep cyclicals (see my recent post Commodities poised for revival). Until the late cycle commodity stocks roll over, there is probably more upside to stocks from these levels, but I am still looking over my shoulder and defining my risk parameters carefully.





Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

Would you short this?

Look at this four-year weekly chart. Would you buy, sell, or hold this?

I will write about what it is on Monday and discuss it further.


Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

Commodities poised for revival

Yesterday's stock market selloff was an event that we haven't seen in some time, as major averages fell over 1% across the board - and globally. Nevertheless, I saw a glimmer of hope for the bulls, as commodities were performing well despite the carnage. If a deep cyclical sector like that is displaying rising relative strength, it suggests that the end of this correction may not be too far off.


Commodities unloved and washed out
Simply put, the commodities complex is unloved, washed out and showing signs of investor capitulation. The chart below from BoAML shows the aggregate large speculator (read: hedge fund) net position from the Commitment of Traders report in the CRB Index. Large speculators have liquidated their net long positions from a near crowded long level to net short. Moreover, readings are consistent where declines have halted in the past.

Here in Canada, the junior resource companies are beyond washed out. The chart below of the relative performance of the junior TSX Venture Index against the more senior TSX Composite is at all-time lows - and below the level of the capitulation lows seen following the Lehman Crisis.

Here in Vancouver, which is the heart of junior mining country, I personally know of scores of well-qualified people who are in the industry who are struggling with the difficult environment.


Green shoots
In the midst of this bleak landscape, I am seeing nascent signs of recovery for the sector. What is encouraging was the positive performance shown during yesterday's ugly selloff. One of the top recent performers has been industrial metals, which has:

1. Rallied through a downtrend;
2. Staged an upside breakout through a wedge; and
3. Staged an upside breakout through a resistance level yesterday - which was impressive given the headwinds provided by the risk trade.

At the same time, gold seems to have made a temporary bottom and it's starting to grind upwards as the precious metal is displaying nascent upside strength.

I am watching carefully the Brent price, which is a better proxy for world oil prices, for signs of an upside breakout through a downtrend. We almost achieved the breakout yesterday, but not quite.

The relative performance of energy stocks against the market is starting to show positive relative strength, which is another early warning of shifting leadership.

Macro and market implications
While I understand that commodities and commodity related stocks are unloved, washed out and poised to rally. These combination of sold-out sentiment and early signs of rising relative strength are pointing to a recovery in these sectors.

From a macro perspective, the recovery of deep cyclical sectors like these are consistent with a relatively upbeat outlook for growth economic growth. In that case, the environment for equities is encouraging and any correction should be relatively shallow - barring any macro surprises,




Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

Should you have sold in May?

All it took was someone to whisper "Fed tapering" and volatility has returned with a vengeance to the markets. I explored this topic in late April (see Sell in May?) and outlined various criteria for getting bearish. For now, most of them haven't been met, which means that I am still inclined to give the bull case the benefit of the doubt.

Surveying the Big Three global economies (US, Europe and China), I see signs of healing - which suggest that markets are likely to continue to grind higher, albeit in a volatile fashion. Let's take the regions one by one.


US: Muddling through
As I mentioned, I outlined a number of bearish tripwires in my previous post Sell in May?

• Earnings getting revised downwards, or more misses in earnings reports;
• More misses in the high frequency economic releases;
• Major averages to decline below their 50 dma; and
• Failure of cyclical sectors to regain their leadership and defensive sectors to outperform.

With the exception of high frequency economic release data, none of the aforementioned tripwires have been triggered. The chart below shows the decline in the Citigroup Economic Surprise Index, but my own personal impression of high frequency economic data is that the results have been mixed. Even then, bad news may be good news as a weakening economy may provide the impetus for the Federal Reserve to delay any tapering of QE-infinity.

We will have a major test of market psychology this Friday. Supposing that the Non-Farm Payroll misses expectations, will the markets react positively because it is another data point supportive of further QE, or negatively because employment isn't growing as expected?

In the meantime, the major market averages remain in a well-defined uptrend. So why are traders so skittish?

In fact, market participants have been so skittish that it only took a minor decline in the major averages for the percentage of bulls from the AAII survey to tank from a crowded long reading (chart via Bespoke). This kind of nervousness do not typically mark major market tops.

In late April, I also wrote that the bearish case also depended on the continued leadership of the defensive sectors and for cyclical sectors to continue to underperform. Well, those trends reversed themselves dramatically in the month of May. The relative performance chart below of Utilities (XLU) and REITs (VNQ) against the market shows that defensive and yield related sectors took a huge hit in the month:

Meanwhile, cyclical sectors as measured by the Morgan Stanley Cyclical Index have started to turn up against the market. What's more telling is the fact that cyclical sectors performed well in Friday's market selloff.

Europe: The next step in the Grand Plan
Across the Atlantic, I am seeing signs of healing in Europe (see Europe healing?) What's more important is the fact that eurozone leaders are taking steps beyond pure austerity measures to address their structural problems.

Recall during the eurozone crises, many analysts said that there were only two solutions to eurozone problems, which was a competitiveness gap between the North and South. Either Greece (or insert the peripheral country of your choice here) leaves the euro and devalues to regain competitiveness, or the North (read: Germany) makes an explicit political decision to subsidize the South. It appears that the latter is happening (from The Guardian) and the focus issue is youth unemployment:

The French, German and Italian governments joined forces to launch initiatives to "rescue an entire generation" who fear they will never find jobs. More than 7.5 million young Europeans aged between 15 and 24 are not in employment, education or training, according to EU data. The rate of youth unemployment is more than double that for adults, and more than half of young people in Greece (59%) and Spain (55%) are unemployed.

Der Spiegel echoed the German "party line" about youth unemployment:

But a new way of thinking has recently taken hold in the German capital. In light of record new unemployment figures among young people, even the intransigent Germans now realize that action is needed. "If we don't act now, we risk losing an entire generation in Southern Europe," say people close to Schäuble.

The new solution is now direct country-to-country assistance instead of assistance through the usual EU institutions [emphasis added]:

To come to grips with the problem, Merkel and Schäuble are willing to abandon ironclad tenets of their current bailout philosophy. In the future, they intend to provide direct assistance to select crisis-ridden countries instead of waiting for other countries to join in or for the European Commission to take the lead. To do so, they are even willing to send more money from Germany to the troubled regions and incorporate new guarantees into the federal budget. "We want to show that we're not just the world's best savers," says a Schäuble confidant.

The initial focus of the direct assistance is Spain:

Last Tuesday, Schäuble sent a letter to Economics Minister Philipp Rösler in which he proposed that the coalition partners act together. "I believe that we should also offer bilateral German aid," he wrote, noting that he hoped that this approach would result in "significant faster-acting support with visible and psychologically effective results within a foreseeable time period."

Schäuble needs Rösler's cooperation because the finance and economics ministries are jointly responsible for the government-owned KfW development bank. The Frankfurt-based institution is to play a key role in the German growth concept that experts from both ministries have started drafting for Spain. Spanish companies suffer from the fact that the country's banks are currently lending at only relatively high interest rates. But since it is owned by the German government, the KfW can borrow money at rates almost as low as the government itself. Under the Berlin plan, the KfW would pass on part of this benefit to the ailing Spanish economy.

This is how the plan is supposed to work: First, the KfW would issue a so-called global loan to its Spanish sister bank, the ICO. These funds would then enable the Spanish development bank to offer lower-interest loans to domestic companies. As a result, Spanish companies would be able to benefit from low interest rates available in Germany.

The concerns over youth unemployment isn't new. ECB head Mario Draghi spoke about the structural problems relating to youth unemployment in early 2012 (see Mario Draghi reveals the Grand Plan). In a WSJ interview, Draghi discussed what he believed it took to solve the youth unemployment problem [emphasis added]:

WSJ: Which do you think are the most important structural reforms? 

Draghi: In Europe first is the product and services markets reform. And the second is the labour market reform which takes different shapes in different countries. In some of them one has to make labour markets more flexible and also fairer than they are today. In these countries there is a dual labour market: highly flexible for the young part of the population where labour contracts are three-month, six-month contracts that may be renewed for years. The same labour market is highly inflexible for the protected part of the population where salaries follow seniority rather than productivity. In a sense labour markets at the present time are unfair in such a setting because they put all the weight of flexibility on the young part of the population.

The first step in the Grand Plan was to gradually go after all the entrenched interests of people with lifetime employment and their gold-plated pension plans, etc. In other words, get rid of the European social model:

WSJ: Do you think Europe will become less of the social model that has defined it?


Draghi: The European social model has already gone when we see the youth unemployment rates prevailing in some countries. These reforms are necessary to increase employment, especially youth employment, and therefore expenditure and consumption.

WSJ: Job for life…

Draghi: You know there was a time when (economist) Rudi Dornbusch used to say that the Europeans are so rich they can afford to pay everybody for not working. That’s gone.

Now that they are taking steps to clean out the deadwood, the next thing to do is to plant, i.e. directly address the youth unemployment problem. These are all positive structural steps and, if properly implemented, result in a new sustainable growth model for Europe.

In the meantime, the Euro STOXX 50 staged an upside breakout in early May and, despite the recent pullback, the breakout is holding:

Stabilization in China
The bear case for China is this: The leadership recognizes that the model of relying on infrastructure spending and exports to fuel growth is unsustainable. It is trying to wean the economy off that growth path and shift it to one fueled by the Chinese consumer. Moreover, it has made it clear that given a choice between growth and financial stability, the government will choose the latter. This was a signal that we shouldn't expect a knee-jerk response of more stimulus programs should economic growth start to slow down.

Indeed, growth has slowed as a result. The non-consensus call I recently wrote about is that China seems to showing signs of stabilization (see Even China join the bulls' party). Since that post, further signs of stabilization is also coming from direct and indirect indicators of Chinese growth.   First and foremost, China's PMI came out late Friday and it beat expectations (from Bloomberg):

China’s manufacturing unexpectedly accelerated in May, indicating that a slowdown in economic growth in the first quarter may be stabilizing.

The Purchasing Managers’ Index rose to 50.8 from 50.6 in April, the National Bureau of Statistics and China Federation of Logistics and Purchasing said in Beijing yesterday. That was higher than all estimates in a Bloomberg News survey of 30 analysts and compares with the median projection of 50, which marks the dividing line between expansion and contraction.

Moreover, the KOSPI in nearby South Korea, which exports much capital equipment into China, is behaving well. This is somewhat surprising as South Korea competes directly with Japan and the deflating Japanese Yen is undoubtedly putting considerable pressure on the competitiveness of Korean exports:
 

Other indirect indicators of Chinese demand such as commodity prices are stabilizaing. Dr. Copper rallied out of a downtrend and appears to be undergoing a period of sideways consolidation.  

A similar pattern can be seen in the industrial metal complex:

Oil prices, as measured by Brent (the real global price), is also trying to stabilize:  

Key risks
In summary, the overall picture seems to be one of stabilization and recovery around the world. In such an environment, stock prices can continue to move higher in a choppy fashion. There are, however, a number of key risks to my outlook:

• US macro surprise: If we get an ugly NFP this Friday and further signs that US macro picture is slowing, it will negatively affect the earnings outlook and deflate stock prices.
• Japan: John Mauldin has a succinct summary of the issues facing Japan that I won't repeat but you should read (see Central Bankers gone wild). The issue of a blowup seems to be one of timing and a catastrophic outcome could be close at hand. With bond yields spiking, how will the economy adjust to rising rates? Already, Toyota has pulled a bond issue because of rising rates. Zero Hedge pointed out how JPM has postulated that "a 100bp interest rate shock in the JGB yield curve, would cause a loss of ¥10tr for Japan's banks":

The rise in JGB volatility is raising concerns about a volatility-induced selloff similar to the so called “VaR shock” of the summer of 2003. At the time, the 10y JGB yield tripled from 0.5% in June 2003 to 1.6% in September 2003. The 60-day standard deviation of the daily changes in the 10y JGB yield jumped from 2bp per day to more than 7bp per day over the same period.
As documented widely in the literature, the sharp rise in market volatility in the summer of 2003 induced Japanese banks to sell government bonds as the Value-at-Risk exceeded their limits. This volatility induced selloff became self-reinforcing until yields rose to a level that induced buying by VaR insensitive investors.

• An emerging market blowup and subsequent financial contagion: The hints of Fed tapering have negatively affected the emerging market bond market and they are starting to roll over against Treasuries. I am monitoring this chart of emerging market bonds against 7-10 Treasuries carefully for signs of market stress and contagion.

The Short Side of Long has indicated that, in general, sentiment towards equities remain at frothy levels which suggests that a short-term pullback may be in order, However,  I am still inclined to stay long equities on an intermediate term basis and give the bulls the benefit of the doubt, but at the same time watching over my shoulder for signs of trouble.      



Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.