A month ago I posited that the general investment and economic consensus would likely be proven wrong for their 2012 outlooks which were calling for a weak first half and strong second half. The two biggest catalysts I cited were central bank reserve expansion coupled with prior easing inflationary trends. Over the course of the last several weeks these twin tailwinds remain and have even strengthened.
S&P 500 Held Captive by the Euro No More
In last month’s article, “Central Banks to the Rescue,” I highlighted how the S&P 500 was highly correlated to European credit fears. Last month’s chart and its explanation are provided below:
The top panel is the S&P 500 (Black) and the Euro (Blue). I have the Euro Ted Spread (Green) and the 2-Yr EUR Currency Swap (Red) in the middle panel (shown inverted for directional similarity), and the third panel is the correlation of the S&P 500 to the EUR currency. The S&P 500 and the Euro are the most correlated they have been since the bull market began. Here is a quick summary of the figure below:
- When the EUR rises the S&P 500 trends up
- When the EUR begins to fall the S&P 500 stops advancing (RANGE BOUND)
- When the EUR is in free fall the S&P 500 finally sells off.
Source: Bloomberg
Main Point: If the EUR can stabilize and bottom then I would expect the S&P 500 to rally. If the EUR slowly grinds down then I think the S&P 500 remains range bound as long as US economics improve. If the EUR goes into free fall then the S&P 500 could sell off hard.
Watching: Looking for recovery in Euro and associated sell off in Europe-based credit spreads (shown inverted in middle panel).
Update: What I was looking for has occurred (easing European credit spreads and rebounding euro) and the S&P 500 broke out of resistance and has been on a tear this month.
Source: Bloomberg
All Eyes on the Euro
Last month I suggested tracking the Euro closely due to its close correlation to the S&P 500 and that we were presented with a good technical setup for a Euro rebound. I mentioned we met the conditions required for a weekly TrendStall BUY signal on the Euro and just needed one week’s downtick to get the official BUY signal. We did in fact receive a buy signal on the Euro and its weekly MACD looks ripe for a confirming BUY signal and with a still low weekly RSI reading of 44.73, the Euro could rally a considerable length before becoming overbought. An updated chart from last month’s article is presented below.
Source: Bloomberg
The Euro rally may extend further than most anticipate as European economic activity is likely to continue to surprise to the upside. The M1 European money supply growth rate is rising again and this historically indicates an improved manufacturing outlook for the region.
Source: Bloomberg
Economists continue to lag behind the economic curve for Europe as seen by the rising Citigroup Economic Surprise Index for Europe (red line below), and will most likely be revising up their forecasts which will improve Euro sentiment and likely cause it to catch a bid ahead.
Source: Bloomberg
Two Major Tailwinds Bears Should Respect
As highlighted last month, easing inflationary pressures and central bank largesse are two powerful forces that are providing twin tailwinds to global equities. In October (A Window of Opportunity) I highlighted that easing inflationary pressures (using the prices paid indexes of regional Fed manufacturing surveys as an inflation proxy) were forecasting a manufacturing rebound to begin in the fall of 2011 and carry over into mid 2012. An update of the chart I used in October is provided below and suggests the US manufacturing base should continue to expand throughout Q1 and possibly begin to slow in the middle of Q2 just as it did in 2011.
Source: Bloomberg
In addition to prior disinflationary stimulus providing a boon to manufacturing, we are also seeing central banks across the globe slashing interest rates and expanding their balance sheets. The world’s big four central banks (US Fed, European Central Bank, Bank of Japan, and Bank of England) are all expanding once more. We are witnessing a third round of global monetary expansion (2008-2009, 2010, and 2011-2012) where the assets of the big 4 combined in USD-terms has grown from more than trillion to nearly .5 trillion over the course of the last year. Each time there is a global currency devaluation race with multiple central banks aggressively expanding their balance sheets we’ve seen the “risk-on” trade accelerate, which means stocks in general (and emerging market and cyclical stocks in particular) should perform well ahead in addition to commodities, which serve as an inflation hedge.
Source: Bloomberg
You’ve heard it said, “Don’t fight the Fed,” meaning it rarely proves profitable to trade against an easing central bank. Right now the slogan should be changed to “Don’t fight the world's central banks.” With prior disinflation still acting as a manufacturing stimulant and with all four of the world’s biggest central bankers expanding their balance sheets, deflationary and defensive assets like bonds and cash are not likely the place to be in the first half of the year.
