Earlier in the month I suggested that we would likely hit a soft patch in Q2 and projected that the markets would remain weak through most of May. However, given the risk of recession remains a remote possibility, any pullback in the markets would serve as a buying opportunity. I believe the U.S. economy is still on a growth trajectory and if an economically weak Europe can reenergize in the second half, then the markets should head higher with cyclical sectors leading the charge.
An economically stronger Europe would likely coincide with a rally in the Euro relative to the USD, adding another catalyst for cyclicals who benefit from exports (industrials, technology) and higher commodity prices (energy and basic material sectors). While the economy and S&P 500 may continue to consolidate through May, many cyclical sectors have already experienced meaningful pullbacks and may bottom even sooner. In such a case, investors may want to get their shopping list ready.
Biggest Second Half Catalyst = Europe
I argued last week that we could see a decent recovery in Europe in the second half of the year, which should boost global GDP. Despite all of the negative economic news coming out of Europe, the Euro Stoxx 50 Index has rallied nearly 7% over the last week and is less than 2% away from hitting a fresh 52-week high! From a technical perspective, the recent pullback after the 30%+ rally from last year’s lows has been very healthy and orderly with the pullback holding the late 2012 breakout above resistance.
Source: Bloomberg
It is likely that European equities are discounting a strong second half by holding firm at current levels. As highlighted in last week’s article, past monetary stimulus and easing commodity prices are likely to be two powerful tailwinds later in the year. In addition to the aforementioned tailwinds, it is possible that we may be nearing the end point for austerity (debt reduction) in Europe which would be a big growth driver going forward and fuel an even more powerful recovery.
It appears European leaders are growing tired of austerity as they’ve seen their unemployment rates continue to climb and their economies contract. Here we see unemployment rates in nations facing massive spending cuts and higher taxes versus Germany and the overall Eurozone. Clearly, austerity is not the cause, but many are now beginning to question its effectiveness.
Source: Bloomberg
More and more leaders within the EU are now openly shifting to a more pro-growth approach with some capitulating on austerity as highlighted by the following two articles (emphasis added).
Era of austerity has run its course, EU says
France and Spain fell short of their budget deficit goals last year and debt levels swelled across the euro zone but the pressure may be easing on Paris and Madrid as the European Commission signals an end to sharp spending cuts…
With budget cuts blamed for a second straight year of recession, the EU's top economics official Olli Rehn indicated over the weekend that more flexibility on tough economic targets was needed. His boss, European Commission President Jose Manuel Barroso, said on Monday that austerity had reached its natural limits of popular support.
"While I think this policy is fundamentally right, I think it has reached its limits," he told a conference. "A policy to be successful not only has to be properly designed, it has to have the minimum of political and social support."
Budget cuts have been at the centre of the euro zone's strategy to overcome a three-year public debt crisis but they are also blamed for a damaging cycle where governments cut back, companies lay off staff, Europeans buy less and young people have little hope of finding a job.
Crippling levels of unemployment and outbreaks of violence in southern Europe are now forcing a rethink, with the focus shifting to economic growth strategies…
Rehn, the EU's economic and monetary affairs commissioner, told Reuters in Washington on Thursday that financial leaders from the group of 20 economies calling for less austerity were "preaching to the converted."
(emphasis added)
Barroso says Europe near austerity limitEurope may have hit the political limits of how far it can go with austerity-led economic policies because of the growing opposition in the eurozone’s recession-hit periphery, the European Commission’s president said on Monday.
José Manuel Barroso said that while he still believed in the need for sweeping economic reforms and drastic cuts in budget deficits, such policies needed to have “acceptance, politically and socially”, which was now at risk…
Mr Barroso’s views are particularly influential because the commission has sweeping new powers to rule on whether struggling eurozone countries are able to ease up on belt-tightening.
(emphasis added)
If Europe does indeed loosen up on austerity, the associated fiscal drag would lessen with economic growth stabilizing. European financial markets are healing and are likely discounting a return to growth, albeit weak growth. If austerity measures are reduced at the same time, the ECB maintains a stimulatory stance. European sovereign bond yields declined sharply this week on the above comments from the European Commission president. While Europe is still a mess, it’s an improving mess—at least that is the message of the credit markets. As seen below, European sovereign bond yields (top panel) continue to decline after peaking in 2011-2012 and credit spreads (bottom panel) rest near multi-year lows indicating there is a lack of financial stress in the system.
Source: Bloomberg
One point I tried to lay out last year was that governments would lean on central banks to print money to monetize massive government debts rather than suffer through austerity and an associated rise in unemployment. Based on Japan’s maturing debt time-bomb, I argued we would see a massive Yen devaluation and associated rise in the Japanese stock market (Massive Japanese Debt Monetization Is Coming, Yen to be Devalued). Since that call we have seen “Abenomics” kick into high gear with a 60% rally in the Nikkei Index in the last five months and more than a 20% decline in the Yen versus the USD since September.
Don’t think European officials do not see the wondrous results from Japan’s great money printing experiment. While the initial response out of Europe towards Japan’s initial devaluation of their currency sparked criticism and concern, we’ve seen an about face in terms of European attitudes towards Japanese monetary policy coupled with a weakening desire towards austerity.
Shares rebound, dollar dips vs yen
Japanese officials said that the Group of 20 nations accepted that the country's .4 trillion stimulus program is aimed at conquering 15 years of deflation rather than at weakening the yen.
"The lack of pushback by the G20 effectively gives the BOJ room to ease further if needed and should keep the yen biased broadly lower," said Omer Esiner, chief market analyst with Commonwealth Foreign Exchange Inc in Washington, DC.
The G20's actions removed any remaining obstacles to further yen weakness, setting up a test of the symbolic 100 yen to the dollar level and boosting demand for Japanese stocks.
(emphasis added)
Could Europe be gearing up for their own grand monetary experiment? European equities have been stuck in a prolonged secular bear market and it appears Japan is attempting to turn the corners with “Abenomics,” Europe may not be too far behind.
Source: Bloomberg
While growth in the U.S. and across the globe may not be particularly strong, there doesn’t appear to be a catalyst in the near term for sustained economic weakness. Given record amounts of debt that needs to be rolled over across the globe (See Global QE Is Coming: Let the Gold Mania Begin!) coupled with withering support for austerity in Europe and strong monetary support by global central banks, we are likely to see continued support for stocks going forward. Consequently, pullbacks like the one we are experiencing now provide good entry points for deploying capital.
A Market Bottom May be Approaching, Get Out Your Shopping List
The S&P 500 had a brief pullback, declining roughly 4% from its April 11th highs to its April 18th lows—not the 10-15% correction many had expected. Part of the reason for the S&P 500 holding up so well is the strength in the defensive sectors which continued to march higher, offsetting the weakness in the more cyclical sectors. The recent slide in the S&P 500 has helped work of an overbought condition but I am not seeing internals yet that would suggest we are near a significant bottom.
Source: Bloomberg
That said, we have seen a greater decline in more cyclical sectors and smaller cap stocks as evidenced by the Russell 2000. Looking at the internals of the small cap Russell 2000 Index does show conditions that have marked prior intermediate lows and why I think we may be nearing a bottom in the market. I believe a bottom will occur first in cyclical sectors and riskier areas of the market like the Russell 2000. To cement that a significant bottom is in I’d like to see a huge thrust higher in the % of Russell 2000 stocks experiencing a MACD buy signal, as evidenced at the June and November lows of last year (see 5th panel below).
Source: Bloomberg
If global growth picks up as I expect in the latter half of the year, then it would make sense for the cyclical sectors to begin to outperform. As highlighted by the Russell 2000, the riskier and more cyclical sectors of the market have achieved conditions seen at intermediate bottoms, though we need to see confirmation of a bottom with a pickup in momentum, as seen by a surge in MACD buy signals. Keep posted!
