Global Business Activity Contracting

Topics Covered

• Global business activity continues to contract
• No confirmation for further highs in a bull market
• Corporate credit spreads continue to widen

Overview

The selling pressure has stopped for now as risk assets and safe havens continue to move in a sideways pattern. It seems that the S&P 500 has experienced a stronger rebound rally than other risk assets, while commodities like Crude Oil and Gold have been struggling. Safe haven assets like US Dollar and Long Bond have paused their vertical rise and have entered corrective mode. The bottom line still remains the same: investors have been selling risk due to possibility of a disorderly default in Eurozone, triggered by Greece as the first domino, followed by a Spanish and Italian contagion. At the same time, Asia and especially China is slowing down meaningfully. At present, bearish trades still remain crowded, but not as much as they were at the start of the month.

Economic Data

Economic data has been weakening meaningfully relative to economist's expectations in every major global region, according to the Citigroup Economic Surprise Indices. Previous instances where economic data disappointed on similar scale, have led to central bank intervention and it is definitely possible we might see that occur again prior to both the US and German elections. Having said that, previous "money printing programs" have only helped the private sector business activity modestly at best, while we have not been able to reach escaped velocity within the current business expansion. In other words, the expansion has failed to become self sustaining. Therefore, ever summer economy weakens, global investors start asking if we are edging closer to another recession?

In China, the HSBC manufacturing index weakened to a seven month low in June, even though the nominal decline was quite small, it confirmed the weakness in both the OECD leading indicator as well as the national PMI. Export orders continued to drop, which signals that China is now being affected by the Eurozone recession and furthermore inventories also increased, signalling that current global demand remains very weak.

In Germany, business confidence continues to deteriorate with ifo German Business CEO Confidence Index moving to new 52 week lows. Relative to other Eurozone indicator, German economy and its private sector with strong export ties, still remain decently robust and growing. But from the recent readings above, it seems that even Germany is now becoming affected by the Peripheral European (PIIGS) recession. Decoupling is always a dangerous word to use in the investment world.

In United States, the Philadelphia Fed General Activity Index dropped substantially to minus 16.6. This is now the lowest reading since August 2011. To put this reading into perspective statistically, this was the 46th worst reading of the 390 monthly readings since July 1980. Regardless of its nominal reading, what concerns me even more is that we now have a major divergence between Wall Street and Main Street, as we can see in the chart above. In other words, there is a major disconnect between the stock market and the economic fundamentals. While stocks have been moving steadily north due to central bank intervention, business activity has been moving steadily south. Eventually, the stock market always moves back towards fundamentals, and further the disconnect between the two, more volatile the move. So let us focus on the stock market.

Equity Markets

The Federal Reserve disappointed investors this week with no balance sheet expansion and only twisting about quarter of a trillion dollars worth of short term Treasuries. Nonetheless, the equity market in the US has still managed to recover decently well from the low levels we saw at the start of June. Many investors are now asking themselves if we will rally further towards 1,400 or are we about to resume a downtrend which started in April?

Intermediate and long term bottoms are usually created during capitulation stages, which are perfectly seen in the chart above. Every time the VIX index spikes above 40, we tend to put in some type of a bottom from which stocks stage a powerful rally. Contrary to that observation, recent 10% correction in the S&P 500 did not see a major volatility spike, therefore it is very difficult to argue that we have formed a very significant bottom at the start of June around 1,266. This is also confirmed by the lack of new monterey stimulus by the Fed (so far) as well as weakening global economy.

Furthermore, US equities seem to be the only major risk asset that have managed to put in new bull market highs in 2012, as can be seen in the chart above. All other major equity indices, risk currencies, commodities and high yielding bonds have failed to better their May 2011 highs and furthermore have also retraced 100% of the Operation Twist and LTRO monetary stimulus programs. In the US, small caps represented by the Russell 2000 have also failed to confirm new 2012 bull market highs that S&P 500 has accomplished.

They say that bear markets slide a slope of hope, so could it be possible that the cyclical reflationary bull market, that started in March 2009, has actually ended last year in May, while majority of investors still seem to remain bullish? Are we all blinded by the outperformance S&P 500 is staging, not to see the rest of the global risk assets trending downwards? And finally, how long can US equities remain in an uptrend on their own?

These are the type of questions I ask myself from week to week as I follow new developments within the economic and market environment. Current business activity is once again slowing as discussed above, global risk assets are disappointing investors, and finally the US equity market breadth is acting rather weak (as we can see in the chart above). The strong rally we witnessed earlier this year was accomplished on very narrow market breadth and bearish divergence. As a matter of fact, market breadth has been narrowing more and more since the cyclical bull market started in March 2009 - a sign of age and maturity. Therefore, there is an above average probability that we could be forming some type of a significant top heading into 2013. It is important to monitor the price in coming weeks and more importantly, monitor what the credit markets are telling us.

Bond Markets

Nothing new to report. Refer to the side menu for previous articles.

Currency Markets

Nothing new to report. Refer to the side menu for previous articles.

Commodity Markets

Nothing new to report. Refer to the side menu for previous articles.

Credit Markets

Just like many risk assets that continue to deteriorate over the recent months, corporate bond spreads also find themselves signalling a similar risk off theme. In the chart above, we can see that Moody's BAA spreads over equal maturity Treasury Bonds, remain elevated above its 200 MA and more importantly continue to widen. It is looking more and more probable that credit markets are pricing in some type of a default event in coming months and quarters, most likely out of Greece. 

The question still remains if Bernanke, Draghi and Co can once again kick the can down the road by engaging into QE3? In today's market environment, the worst things tend to become, the better they tend to become for risk assets (at least for awhile), due to constant central banks money printing and government deficits, which kick the can down the road every so often. While it is most likely probable some type of "can kicking" will occur once again prior to US as well as German elections, I would be very worried about the current fundamental backdrop and would emphasis that markets are starting to lose patience.

Trading Dairy Updates

• After FOMC decision to extend Operation Twist, which disappointed the market (as discussed in Wednesdays post), I hedged my core Silver position by about 25%. Trade was executed as Silver broke the short term triangle as discussed in previous posts. I am also still holding onto core Silver position from late December 2011 bottom at $26 as I know that sentiment is very bearish  and that PMs have strong fundamentals going forward, linked together with huge net long positions in the US Dollar.
• Risk assets still remain on my watch list for some shorter term bullish rebound trades. These include Brent Crude (BNO), Commodity Indices (GCC / RJI), Precious Metals (GLD, SLV, CEF, PSLV, etc) and Agriculture (RJA / MOS). I believe commodities are very oversold right now and should at least bounce soon. I have not done anything major just yet and will not do anything until I hear stronger action from the Fed.
• Global bear market is approaching as the recovery loses steam. I will compile a watch list of assets to short as we get closer to the US / German election, as it is possible that things still hold together until than. I think good shorts going forward are equities (record profit margins), risk currencies (more easing by CBs ahead), corporate and junk bonds (spreads to widen), while good longs are volatility (VIX to spike), CDS (protection from default) and safe haven currencies (to benefit from risk off flows). However, I regard commodities very oversold and bonds very overbought.