| Rodrigo C.

Serrano, CFA
| SIPA | Columbia University
Master of International
Affairs ’14 Candidate

| New York City, NY
| 01-305-510-0181
| rcs2164@columbia.edu

> Overall, the U.S.
economy continues to
expand. Leading
indicators point to a
continuation of the
expansion phase in the
business cycle. However,
growth of internals is now
in flux, reflecting the
repercussions of another
noteworthy headwind now
complementing higher
interest rates.
> From the ISM’s October
Manufacturing report: “The
government shutdown has
not had any impacts on
our business that I can
determine, nor has it
impacted any supplier
shipments. (Chemical
Products)”

The Month that Was: October 2013

This report concisely summarizes the important macro events
over the past month. A more extensive time-horizon is
required to avoid costly psychological traps, which all investors
are prone to, such as representative (sample size neglect) and
availability biases.

Overall, the U.S. economy continues to expand. Leading
indicators point to a continuation of the expansion phase in the
business cycle. However, growth of internals is now in flux,
reflecting the repercussions of another noteworthy headwind
now complementing higher interest rates.

In Washington, officials passed extensions to bring an end to
the government shutdown and raise the debt ceiling. Near-
term uncertainty was lifted and markets rallied in response.
The S&P 500 notched new all-time highs during the month.
However, the short-term nature of the resolution has acted as a
notable headwind for the U.S. economy. Consumer confidence
has soured at precisely the wrong time, just before the pivotal
holiday shopping season. This adverse dynamic now
compliments higher interest rates, which continue to challenge
the housing recovery as covered in my prior monthly report.

Despite these headwinds, bullish news during the month has
more than counterbalanced. To begin Janet Yellen’s
nomination suggests the continuation of loose monetary policy
to aid the recovery; “Don’t fight the Fed.” Furthermore,
preliminary indications in the manufacturing and service
sectors so far demonstrate a limited negative effect from the
near-term nature of the budget and debt ceiling settlements.
On the whole, comments from the Institute of Supply
Management’s (ISM) surveys have been positive; the following
from the manufacturing survey succinctly summarizes general
sentiment: “The government shutdown has not had any
impacts on our business that I can determine, nor has it
impacted any supplier shipments. (Chemical Products).”
Moreover, bullish investors have had the additional tailwinds
of improving global economic conditions.





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6
> The Eurozone has more
or less stabilized. Yet
political risk remains
elevated. Only significant
economic improvement
can diminish it. In my
view, from a social
perspective, the current
state of affairs is
unsustainable over the
medium to long-term.
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!"#$%$&' )*#+,- .)/0
-./01.23045/6 7849528:
Chart: RCS Investments Source: Markit
In Europe

Despite the conspicuously tepid nature of Eurozone economic
improvement, investors have become more sanguine on the
region’s prospects. In regards to the most important periphery
country, Santander Chief Economist Emilio Botin stated that
there had been a “drastic change” in perceptions regarding the
Spanish economy. “Money is pouring in from all sides.
Everybody wants to invest in Spain.” Economic data for
country and the region to an extent supports his claim.

Markit PMI readings for both the service and manufacturing
sectors are soundly above 50, the demarcating integer between
expansion and contraction. Furthermore, the region’s business
and consumer surveys point to continued improvement in
sentiment. Spain in particular has shown betterment. The
country formally exited recession in Q3, posting a 0.1% growth
vs. the prior quarter. Strength was seen in retail sales, which
posted its first positive reading in more than 3 years on a YoY
basis. Exports have also been a contributing factor. In Italy,
retail sales are firming, a positive sign since they make up
roughly 20% of economic activity in the country. Business
confidence is also trending higher. Economic data is set to
improve as evinced in OECD leading indicators for both
countries. Indeed, improving data and falling yields in
periphery sovereign paper are indications that there is light at
the end of the long and arduous tunnel of economic contraction
and austerity. Mario Draghi believes this to be the case. At
Harvard University during the month he thumbed his nose at
Euro critics stating that: “In the dark days of the crisis, many
commentators on this side of the Atlantic looked at the euro
area and were convinced that it would fail. They were
wrong…they had underestimated the depth of Europeans
commitment to the euro.”

Despite signs of improvement in the periphery, suggesting a
light at the end of the tunnel, it is imperative that the current
pace of recovery in the region accelerates markedly. At its
current rate, it is unlikely to materially decrease elevated
political risk. What are the chances of this acceleration when
austerity is set to continue throughout the periphery? Enrico
Letta’s 2014 budget has prompted widespread opposition from
many, including those from within his fragile government
coalition. A renewed emphasis on cutting government
spending is seen as quite regressive in the eyes of the citizenry.




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Chart: RCS Investments Source: ISTAT, INE, National Statistical Service of Greece
> Asia is in the midst of a
rebound. Nonetheless the
outlook remains
significantly clouded given
tepid global trade flows
and souring debt
dynamics in China.
Rolling strikes from Italy’s 3 main trade unions are set to
transpire over the coming weeks. In Spain, the most severe
budget cuts in the country’s democratic history have led to
exports becoming a major pillar of the nation’s recovery. This
again brings to light the fundamental problem with the
Eurozone’s (and global economy’s for that matter) current
economic structure: Not every country in the region can export
its way out of its economic malaise. Germany remains
lethargic in its duty to restructure its economy towards one of
higher consumption. In addition, a rising euro has begun to act
as a headwind for the fragile recovery in the Iberian Peninsula.
Finally, France’s recuperation has significantly lagged that of
Germany’s as per PMIs and industrial production metrics.
This divergent economic performance places front and center
the lack of an optimum currency area in the region, which
translates into the current asymmetric nature of economic
growth.

In sum, there are indeed green shoots of recovery. However,
the region’s environment remains hostile towards their
germination. Austerity is set to endure over the short-term.
Consider this along with the fact that more than 50% of
Greece’s youth remains unemployed and unemployment rates
for Spain and Italy have either notched new or remain near
record highs. This current state of affairs is unsustainable.
Europe’s social gangrene continues to spread. News of the
Golden Dawn’s infiltration into Greece’s police force,
Catalonia’s push for independence from Spain, and solid
results from Marine Le Pen’s National Front Party in recent
elections all serve as evidence that scant economic
improvement has not been enough to decisively turn the social
tide towards a more united Europe. To be sure, there are signs
of improvement. Periphery sovereign yields imply no
disruption over the short-term; however, conditions need to
markedly improve for Europe’s light to actually be the end of
the tunnel and not that of an oncoming train.

In Asia

Bulls can point to Chinese 7.8% YoY GDP growth, which all
but guarantees that the 7.5% target set by officials will be hit,
as an clear indication that a major stanchion of the global
economy has undergone a soft-landing. Both service and
manufacturing PMIs, reported by the China Federation of
Logistics, corroborate this newfound economic strength. What




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Chart: RCS Investments Sources: Australian Bureau of Statistics
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!"#$% '()#*+,* -./
-./ 012 345678 97:17;
Chart: RCS Investments Source: China Federation of Logistics
is interesting to note is that the former has been consistently
outperforming the latter and may suggest that economic
restructuring is taking place within the country. The overall
bullish thesis is further buttressed by improving export metrics
from economic bellwethers such as Australia and South Korea;
China’s stabilization is reverberating throughout the region.
The former recently notched its highest rate of export growth
in almost 2 years, while the latter hit a 7-month high. Yi
Gang’s comments of growth surpassing the government’s
target were prescient. His further claim that economic growth
would maintain near 7% for the foreseeable future would be a
powerful arrow in the bulls’ quiver.

October was also a kind month for Japan, the world’s 3
rd

largest economy. A Markit/Nomura Securities PMI reading of
54.2 was the highest in more than 3 years and is a whisker
away from the highest in more than 6 years. This bullish
metric is endorsed by a solid Tankan survey for large
corporations, which hit its highest level since 2008. What’s
more, core machinery orders, an important leading indicator,
marked its 4
th
consecutive month of growth in August.

While there was plenty of good news for the month, there are
worries that China’s growth is unsustainable and dependent on
excessive credit growth. Furthermore Japan’s trade numbers,
in addition to tepid new export orders within China’s PMI and
the lowest export volume since 2009 in this year’s Canton Fair,
give credence to the bearish claim that global trade flows are
not picking up. It is noteworthy that despite higher export
numbers from Australia, they primarily compromise of higher
iron ore, a sign that China’s growth has been due to stimulus
projects and further fixed-asset investment; the government’s
longstanding dependence on this source of growth continues.
Regarding the aforementioned Chinese PMI indicator,
October’s reading of 51.4 was actually a regression from last
month’s preliminary reading of 51.5 (which was later revised
downward to 51.1). There is also the added uncertainty of
whether the inflation cycle has bottomed. An October reading
of 3.2% is just a hair beneath the central bank’s target of 3.5%.
This may hamper efforts to further stimulate. However, a
bullish rebuttal is that a negative PPI may aid in restricting
pass through thus containing upward pressure to consumer
prices. Perhaps the most noteworthy non-economic news bit
came from Fitch Ratings, which warned “that the pace of loan
growth over the last five years takes China into unchartered




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9
> Manufacturing remains
in growth mode. Near-
term outlook remains
constructive. Government
shutdown has not affected
business activity in this or
the service sector.
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Chart: RCS Investments Source: Institute for Supply Management
waters, with debt jumping from $9 trillion to $23 trillion, or
200pc of GDP. The economic ‘efficiency’ of debt has
collapsed. Each extra yuan of debt now yields just 0.18 yuan
of GDP growth.”

In sum, there are signs that the Asian region is in the midst of a
rebound. Improved metrics ranging from China’s 3
rd
quarter
GDP, accelerating exports from Australia, a bottoming of
exports in South Korea, to improved price action in
commodities such as iron and steel imply that economic activity
has picked up. However, this has not translated into improved
global trade flows as of yet. Also, more investors have become
concerned with the quality of China’s growth. Dependence on
fixed asset investment and large amounts of credit extended to
support these projects may lead to souring asset quality, which
may precipitate a banking crisis in the communist country. Is
the region’s economic rebound sustainable?

_______________________ _______________________

In the U.S.:

Passage of short-term resolutions to reopen the government
and prevent a disastrous default has lifted the immediate cloud
of uncertainty. I have been keen on discerning how the short-
term nature of the resolutions would affect confidence. The
results have been mixed.

Manufacturing and Services:

On the bullish end, manufacturing’s renewed upturn, which I
covered in last month’s report, continues. Even better, there
have clearly been no negative effects resulting from the
government shutdown or a lack of a long-term compromise.
ISM manufacturing and service indices imply both sectors are
humming along. The strength of the service sector, which
accounts for close to 70% of the U.S. economy is admirable. 3-
month averages for business activity and new orders remain
solid, though persistent weakness in backlogs indicates an
economy growing in fits and starts. Furthermore high
frequency indicators, such as the American Association of
Railroad’s intermodal traffic and the American Trucking
Association’s Truck Tonnage Index show that the arteries of
the real economy are bustling.




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:
> The Chicago Purchasing
Manager’s Index logged its
fastest pace of growth in
over 30 years!
> Overwhelming souring
consumer sentiment, less
than 2 months before the
all-important holiday
shopping season, is cause
for concern.
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Chart: RCS Investments
Source: University of Michigan


On the basis of these indicators there is little sign of recession
around the corner. However economic turbulence may rise
early next year.

The Consumer and Job Market:

The deterioration of consumer confidence and feeble growth in
retail sales, likely resulting from the government shutdown and
its uninspiring settlement, is alarming. An overwhelming
souring of consumer sentiment was indicated by the Gallup
Poll’s confidence survey, which notched its lowest level in more
than a year; the Bloomberg Consumer Comfort index, which
erased all of its 2013 gains; and the University of Michigan’s
sentiment index, which fell to levels last seen in late 2011.
Only the Conference Board’s consumer confidence survey
indicated more or less stable sentiment. These predominantly
negative readings, less than 2 months before the all-important
holiday shopping season, is cause for concern. This sentiment
is further verified by various spending metrics such as a
slumping Discover Spending Monitor, weakening light vehicle
sales rates, and subdued growth in retail sales.



To be sure, there are tailwinds at work that may lead to better
than expected consumer spending over the coming months.
Falling gas prices equate to a de facto tax cut with immediate
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Chart: RCS Investments Source: Discover
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Chart: RCS Investments Source: American Association of Railroads




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;
> The labor market
continues its choppy
recovery. Leading
indicators imply a
constructive outlook.
effect. Moreover, a pick up in disposable income growth over
the past 3 months, from a YoY rate in the low 2% range to near
3%, is also reason for optimism. Last but certainly not least is a
healing job market. The October establishment report was
much better than expected. 212K private sector jobs were
created, which was higher than the 3 and 6-month average and
the 2
nd
highest reading of the year. Jobless claims have begun
to descend, albeit slowly. Even better, leading indicators, such
as the Employment Trends Index (ETI), published by the
Conference Board indicate that strength lies ahead. Gad
Levanon, Director of Macroeconomic Research stated: “In
contrast to the gloomy headlines from Tuesday’s jobs report
[for September], the ETI signals upward momentum in labor
market conditions in the months ahead.”

As an afterthought, given the drubbing that Republicans took
at the polls regarding the budget and debt ceiling standoff, it is
unlikely that we will see extreme gridlock similar to what
occurred this past month. This thought may bolster confidence
in the months ahead.