Steen's Chronicle: Maximum intervention revisited

The main theme in this week's macro meeting was the Fed and how Bernanke would play his cards at the Kansas City Fed's annual Jackson Hole meeting Thursday and Friday. The ECB is now on the back burner until after the German Constitutional Court ruling on September 12.

So to start off, let’s have a look at gauging what the Fed/Bernanke will do:

• We figure 70% odds of the Fed changing "something" rather than a mere repeat of the unspecific rhetoric we’ve see up to this point. If the Fed moves forward/hints at what its next steps will be, we give 80% odds that it will merely be an extension of the commitment to keep rates low through 2015 (vs. current “late 2014”). So the odds of this specific outcome is on the order of 56% (0.70 x 0.80).
• There is a 14% probability the Fed will hint at a full QE programme (0.70 x 0.20) in the pipeline.
• This is based on the following analysis: taking the August FOMC minutes at face value: the Fed said that it will move "fairly soon" if data does not improve substantially and sustainably. Is "fairly soon" September from August or rather  giving the market a little something (2015) in the September meeting only to go full steam ahead in October if the data continues to disappoint?
• The Fed and policy makers tend to err on the defensive side. The Fed knows they may need some ammunition to deal with the possibility of, for example, an ECB disappointment, the Constitutional Court ruling in Germany and, as always, the Greek tragedy. And to this we can add three relatively new global macro risks: Iran vs. Israel (energy prices), the food & energy price spikes during July/August, and China is slowing at a scary pace.

This adds up to a one-two punch from the Fed. The first punch (a 2015 extension) will be somewhat weak and disappointing for the market, but the second one may be more powerful. Bernanke and the other FOMC doves have clearly decided they want to "help the economy", but the Chairman needs to listen to his board first before forcing a stronger bias. September may prove too early, as there may be enough hope from the recent stronger US data (see chart below) since the last FOMC meeting to stave off drastic measures at this stage. 

The Fed does not believe that even lower rates will trigger any new economic miracle, but their dual mandate is increasingly becoming a single mandate: create conditions for jobs, so it’s very likely that they will eventually do anything at the margin.  That's whether it’s in the name of lowering interest rates or a de facto effort to continue effectively financing a sizeable chunk of the US deficit - to prevent the perceived need for up-front federal budget austerity and all of the immediate negative effects on jobs and growth that this would bring.

The Jackson Hole speech will probably have something for everybody, but ultimately it will not provide the juice needed to pull this market above the 1425/1450 range for now.

The Dow Theory divergence remains in place. (The Dow transports are flat to down while the industrials recently pushed to multi-month highs.) The VIX has risen slightly, but remains subdued and High Yield performance is reaching the high for the year based on "yield chasing". Please see comments I made on CNBC on High Yield yesterday morning.  

China
We actually started our macro meeting discussing China. We were somehow confused at how the dismal performance of Chinese growth and the stock market remain "unnoticed" by Wall Street and Canary Wharf. It was, let us remind you, the anticipated fiscal stimulus from China which "saved" the markets at the end of May. Fast forward to the end of the summer and the Chinese stock market continues to set new cycle lows, and growth and production is fairly "collapsing" by Chinese standards. Hong Kong GDP, our proxy for China, actually experienced a negative growth number for the last quarter!

China is one generation into Deng Xiaoping's Four Modernisations, which started in 1978/79, and it’s about time for The Party to make changes. These changes should be about more openness and competition, but recent political instability means there is the increased risk that China will turn inwards rather than outwards over the next five years. Every generation is met by a new cycle, I believe that China is about to go through a series of important changes that won’t necessarily mean poor growth beyond the near term risks, but it will require important political changes and economic changes that will see a reduction in global imbalances. China was a huge part of the economic environment in the 1990s and into the early 2000’s with its cheap production that forced inflation down in Europe and the US. But now with the huge imbalances in trade and current account, China has become too successful not only for the rest of the world, but also for itself. 

The Chinese slowdown is bad for global growth over the balance of 2012, but it’s extremely positive for the global imbalances and is one of the reasons we are increasingly bullish on this year being the "cycle low" for growth and probably also valuations of stock markets.

US Fiscal Cliff
The fiscal cliff in the US threatens the only real positive story at the moment, the slow US recovery. Let's remind ourselves what the end-2012 fiscal cliff will mean: if no major new deal is struck, spending cuts and tax increases will be automatically triggered to the tune of USD 600 billion, or approximately 3.7 per cent of GDP (this, by the way, is more austerity than any European Club Med country is willing to do).

However, as always, a compromise is expected, as the consensus among Wall Street names is that a new pact might limit the fiscal reduction to 0.5-1.0 per cent of GDP. Why is the fiscal cliff important to the stock market? A rule of thumb says that a 1 per cent shift of GDP equals USD 5-7 in earnings per share for the S&P500. Ergo, consensus EPS expectations for the S&P500 for 2012 are USD 100, which means a P/E of 14.0-15.0, making fair value 1400-1500. Subtract USD 5 and you now have 1330-1425 if we assume the same multiple - a huge difference. No new fiscal deal and we’re talking about a cliff indeed if we have to wipe out USD 20 of forward earnings expectations.

The “death of equities” in the media and among pundits is a strong indication that we need to look for signs of improvement rather than doom-and-gloom. Still, we do need a "mandate for change", not only in Europe, but also in the US if we want to get back on the right track.

Having said that, I remain very constructive on risk medium- and long-term, but still feel a final test down is needed. I expect a 20-30 per cent correction to set-up the catalyst for a major bull market. Return on equity in the S&P500, excluding financials, has been > 20 per cent, not bad for the 'micro-economy' and proof that the real economy performs despite the continued inaction and mistakes made by policy makers and central banks.

The next tests for the market and the economy besides the Jackson Hole conference this Friday will be next week’s ECB, the Dutch elections and German Constitutional Court ruling (both on September 12) and finally Greece and the review of its reform efforts.

As for asset allocation, we're keeping our powder dry, but expect the attitude of maximum intervention and extend-and-pretend to continue as we head for a major correction near term. Policy makers won’t be stopped by the last four years of poor results. They'll just tell everyone to imagine how bad things would have been had they done nothing.

Safe travels,
Steen