Naufal Sanaullah

naufal.sanaullah@gma il.com @naufalsanaullah

Technical & Macro Market Update

November 12 2 01 1

MARKET COMMENTARY BY NAUFAL SANAULLAH

MARKET THEMES
Bullish
 US data is surprising to the upside  The US consumer appears to be back  US corporate profits at record highs  Chinese inflation is easing  Political hurdles to European bailout disbursement have been addressed

Bearish
 US incomes are declining and consumption is being financed out of lower savings  US corporate margins have nowhere to go but down  Chinese data continues to come in weak  Beijing proper ty prices down 5.1% Y TD  Still no mechanism to sustainably keep Italian yields depressed  EFSF paper seeing low demand  Eurozone recession is getting wor se

US GROWTH
 Manufacturing indicators are leveling out
 Composite PMI remains barely above 50, after contracting from above 60  New Orders are ticking up, and New Orders/Inventories difference sharply ticking back above zero, signifying tailwinds  Trend direction remains to be seen, but recession calls are looking premature in light of recent data

 Advance Q3 GDP prints at 2.46%
 Using BLS-based deflators, real Q3 GDP grew by 2.94% YoY  Wednesday’s September wholesale inventory data printed at -0.1% vs +0.5% expected, causing pervasive Q3 GDP downgrades from 2.3 -2.6% to 1.6-1.8%  Consumer improvements in goods & services spending was the biggest factor in the upswing  Real GDP ticked up to 2.9% in Q2 2007, directly before recession began

 Impor t prices from China rose 0.4% MoM, as EM inflation expor ted from Fed policy (through FX & trade channels) come back home to roost and boost domestic inflation

US GROWTH

Source: Douglas Short

US CONSUMPTION
Is current consumption growth—which drove growth in Q3—sustainable, considering:
 Per-capita disposable income is declining by 2.32% annualized?  US savings rate is back to pre-recession levels?  Prospects of rising taxes are growing?  Recent consumption data could be mainly due to easing energy & food prices in Q3?  These same food & energy prices have reversed their entire Q3 declines in October alone?

INCOMES
 The gap between incomes and spending is worrisome  This is especially so when considering that more than 20% of personal income is from government transfers  Are incomes set to drop even further as deficit worries subsume the Washington debate?  What would be the consequent impact on spending?
Source: Street Talk Live

US SAVINGS RATE
 The US savings rate is now back down below the 4% level  This level has roughly demarcated between sustainable, organically financed consumption and unsustainable, overleveraged consumption  The savings rate stayed below 4% from 1999-2008, which were years characterized by excess debt and unsustainable consumption

Source: Federal Reserve Bank of St. Louis

HOUSEHOLD DELEVERAGING
 Household debt service (mortgage & consumer debt) and financial obligation (auto & rental leases, homeowners’ insurance, and property tax) ratios to disposable income are still plunging  Household deleveraging doesn’t appear to be nearing completion  Because of secular nature of current down cycle in credit, these ratios should remain near the lower end of their ranges for an extended period of time, even after finally bottoming
Source: Federal Reserve Bank of St. Louis

HOUSEHOLD DELEVERAGING
 Household debt is still not growing  Money velocity may finally start ticking up once YoY household debt growth (see chart) breaks back above the 0 level  Until then, rumors of the completion of household deleveraging appear to be greatly exaggerated
Source: Federal Reserve Bank of St. Louis

HOUSEHOLD DELEVERAGING
 Consumer debt as a ratio of disposable income has a long way to fall yet  To unwind the great leveraging of the 1990s 2000s, this ratio must drop below the 1 level  If incomes are set to drop further, then debt will have to decline even more incrementally in order for any further necessary deleveraging to occur  This timeframe and narrative fits well with the “three to four years”
Source: Federal Reserve Bank of St. Louis

ECRI INDICES
 ECRI leading index (chart on top) in sharply negative territory, below mid2010 lows  Unlike 2010 slowdown, ECRI coincident index (chart on bottom) is approaching a break below the 0 level
Source: Economic Cycle Research Institute

EMPLOYMENT
 Initial claims continue to have a difficult time sustaining a break below 400k  Without sustained real GDP growth above 2%, the unemployment rate will likely not sustain a break below 9%  Public sector employment is a big question mark in the current political climate, especially on state & local levels

Source: Federal Reserve Bank of St. Louis

WILL TOP-LINE CONTRACTION CAUSE MARGIN COLLAPSE?

Source: Bianco Research via Barry Rithotlz

RECESSION?
 A US recession in 2012 seems possible, given:
 The implications of an escalating Eurozone crisis on investment  The unclear sustainability of strong consumption growth in the face of a savings rate back below 4%  Political uncertainty and prospects of fiscal consolidation  Weakening EM demand for US exports (mainly from infrastructure spending that is now being unwound)

 Any such recession would be likely to be shallow, especially relative to 2007-2009, given already existing excess capacity and nature of secular deleveraging -driven balance sheet recessions  With homeownership rates still so high and ineffective policy responses to address housing woes, a reversal of housing’s impact on GDP is unlikely in the foreseeable future  Without a major housing recovery, the overall recovery could lose its legs, particularly since exports & government expenditure (both facing major headwinds going forward) have been the two most positive drivers of GDP since Q4 2007  For now, a strong auto sector and continued business investment into software equipment & technology are allowing expansion

FEDERAL RESERVE POLICY
 Inflation (headline CPI almost at 4%, core at 2%) is becoming a constraint on fur ther Fed QE, at least at the moment  However, the prospects of outright MBS purchases seem to be rising, as policy from Congress & the White House are proving futile  Many economists have suggested the Fed engage in nominal GDP targeting  The implications of such a policy on inflation, as well as the exact mechanism by which central bank asset purchases can directly impact NGDP, are impor tant questions regarding NGDP targeting  However, price/level targets as opposed to size/aggregate targets are much more credible and ef fective monetar y policies, as the transitor y ef fects of the various QEs can attest  Still, at this point the Fed seems politically constrained from fur ther action and will be unlikely to step back in unless conditions deteriorate substantially fur ther  If and when the Fed does implement NGDP targeting, the “great inflation” may finally begin

CEOS ARE LOSING CONFIDENCE…

Source: Goldman Sachs

…AS ARE CONSUMERS

Source: Conference Board

US EQUIT Y MARKET
 Af ter spending October ver y closely tracking EUR/USD, the S&P 500 has now decoupled a bit from external macro risks  Whether this decoupling can be maintained likely depends on if the Eurozone crisis can finally be contained (unlikely in my opinion)  Bull market leader s showing sharp underper formance and high volume selling, including breakdowns and failures at 55dma’s  Unit labor costs bottoming (real unit labor costs at 60 year lows & wage share of GDP at 50 year lows): corporate margins nowhere to go but down?  Sentiment has shif ted dramatically to now being excessively bullish  The market crashed due to the debt ceiling debacle’s implication on potential domestic austerity, as well as immediate threats arising from Italy & Greece  Although political changes have been made, the structural problems in Europe remain and continue to escalate as austerity impacts growth, suggesting the market may be indicating complacency

US EQUIT Y MARKET
 Still over valued, as per Shiller’s CAPE index  Secular deleveraging should return CAPE back to single digits before a long term bottom is put in  The key headwinds to multiple expansion at this stage is actually probably EM demand, which is being weighed down by a combination of sticky inflation and a tightening CB cycle in response to massive hot money flows  Overseas demand accounts for half of the S&P 500’s revenue
Source: Robert Shiller/Irrational Exuberance

US EQUIT Y MARKET
 Currently in consolidation zone between S&P 1220 & 1300 and in between 55dma & 200dma  Whether 200dma provides overhead resistance or is broken through will likely determine near -term trend direction  For now, cash appears attractive; break above 200dma could signal retest of highs, while break below 55dma could confirm bear market  Tight holiday liquidity could allow for a market ramp into year end, but it is dif ficult to get constructive on the market for 2012

AAII SURVEY % BULLS

Source: Cullen Roche/Pragmatic Capitalism

S&P 500

S&P 500 VS GOLD
 The US equity market priced in gold remains in a firm, multi-year bear market  Short SPY/GLD remains an attractive position  After breaking and re recovering the 2009 lows, this ratio is consolidating and unsuccessfully testing the 0.83 resistance above  Other equity markets, both developed and emerging, priced in gold appear even better short candidates

HY/EQUIT Y DIVERGENCES

Source: Tim Backshall/Capital Context

LEADING STOCKS
 Wal-Mar t (WMT), Autozone (AZO), and O’Reilly Automotive (ORLY) have been among the best market leader s recently  As Mark Smith obser ves, these are the same stocks that ramped ahead of the 2007 -09 recession  To the right is a char t of the relative per formance of a price-weighted basket of the above stocks vs the S&P  Large-caps with pristine balance sheets continue to outper form growth stocks on a trailing basis  This is a bearish divergence in the medium term

EUROPE
 Italian PM Silvio Berlusconi has now resigned, paving the way for austerity implementation
 Mistimed austerity has thus far only hurt growth; is a new administration a credible solution to Italy’s financing troubles?  If likely successor Mario Monti fails in implementing required austerity or in garnering the required majority for a coalition government, BTP yields would go right back up  Even if austerity is successfully implemented, how will deficit ratios be brought down with austerity’s impact on growth?  According to Edward Harrison, at 6.5% on the 10yr, Italy would need a budget surplus of 5% of GDP (laughable) to keep debt levels simply from rising, let alone falling to sustainable levels  October Italian PMI at a very low 43.3

 Greek PM George Papandreou has also resigned, eliminating the threat of a Greek referendum rejecting the EFSF bailout
 Societal disruption continues to rise, especially since the introduction of a property tax to be collected directly through the state power supply corporation  Although the bailout package is now set to be accepted, general elections in February may bring more hurdles to Greece’s inclusion in the EU bailout

EUROPE
 T h r e e n e c e s s a r y a n d ev e n t u a l l y i n ev i t a b l e p o l i cy a c t i o n s :  Cut benchmark ECB rates to zero  Expand the ECB SMP effectively into an unsterilized QE program  Create a common treasury/fiscal union (possibly by turning the EFSF or ESM into one), funded by the ECB  A f o u r t h a c t i o n m ay b e to e j e c t s o m e c o u n t r i e s f r o m t h e e u r o a l l ow i n g f o r m o r e f e a s i b l e f i s c al i n te g r a t i o n  I t a l i a n & S p a n i s h d e b t r a te c e i l i n g s / t a r g et s s e e m to b e t h e o n l y c r e d i b l e w ay to f i r ewa l l c o u n t r i e s s e e n a s to o b i g to s av e  E C B b i d s h av e h e l p e d I t a l i a n 1 0 y r y i el d s d r o p b a c k b e l ow 7 % , b u t o n l y a p e r p et ua l b i d o r r a te t a r g et a p p e a r s to b e s u f fi c ie n t to ke e p r a te s f r o m r i s i n g b a c k  I s a n E C B b a z o o ka a l l b u t g u a r a n te e d a t t h i s p o i n t , c o n s i d e r i n g :  €174 billion in periphery bonds bought by the ECB through the end of October?  €307 billion in Italian bonds alone to be rolled over in 2012?  G e r m a ny & t h e E C B r e m a i n h aw k i s h h o w ev e r  I t a l y o w e s G e r m a n b a n k s € 1 16 b i l l i o n  Germany will have to choose between a domestic banking crisis and ECB monetization  The only question is: how much worse will things have to deteriorate before the ECB relents?

EUROPE
 Political turmoil in Athens & Rome is making a larger EFSF less likely anytime soon  An attempted €5 billion, 15yr issuance had to be modified to €3 billion, 10yr paper due to poor demand and liquidity for EFSF paper  It is becoming clear that the EFSF in its current form was an ad -hoc policy response that does little more than buy time  EFSF yields remain at record wides  S&P has warned of ratings cuts to several European nations, the most notable of which is France  A French downgrade would render the EFSF moot, as Germany would become the sole backstopper lef t  This could be the catalyst for unlimited ECB inter vention  Lots of bearish economic data recently:
 German Industrial Production down 2.7%  Eurozone retail sales down 0.7%  Spanish GDP growth has stalled

EUROPE
 Contagion is spreading, with Slovenia now seeing yields above 7% as well  Non-EU eastern European nations could become threats to financial stability due to cross-currency liabilities on Eurozone bank balance sheets  Fitch & S&P have both warned of downgrades to Hungar y’s debt  CHF/HUF is back near its highs (see char t to right), unwinding the entire SNB rate target sellof f, making the cross-border funding problems an imminent danger to an already sticky situation

EUROPEAN PMI’S
 October European Manufacturing PMIs showed surprises to the downside
    Italian PMI was 43.3 vs 47.2 consensus vs 48.3 prior French PMI was 48.5 vs 49.0 consensus vs 49.0 prior German PMI was 49.1 vs 48.9 consensus vs 48.9 prior Eurozone PMI was 47.1 vs 47.3 consensus vs 47.3 prior

 German PMI is at lowest level in two years, dragged down by declining export demand, and now in contraction territory  Italian PMI is at sharply recessionary territory and bodes poorly for any attempted increase in government revenues  Austerity is clearly bringing about a sharp European recession, causing a feedback loop by making deficit ratios even higher, forcing further fiscal consolidation and so on

WHY THE EURO ITSELF IS THE PROBLEM

Source: JP Morgan

EUR/USD
 Currently being driven mainly by political and event risks, which are near-term bullish due to Greek & Italian PM resignations  1 .40 level remains the line in the sand  If the ECB continues refusing to step in, Europe could be facing a deflationary outcome that could boost the euro  However, I expect ECB intervention and see EUR/USD as a medium- and long-term sell  If Italian yields jump back up despite Berlusconi’s departure, 1 .29 could be in the cards within the next few months  Sustained trend direction will likely not develop until after holiday liquidity tightening gives way to the new year  Below 1 .35, EUR/USD appears a solid sell

EUR/USD

AUSTRALIA
 Risks from overheated proper ty sector and overreliance on Chinese raw material demand may expose themselves in 201 2-2013  China bear theme finally getting MSM exposure  Q3 housing prices print -2.2% YoY growth, as per ABS  Household debt/liquid asset ratio at around 170% as of Q2 2011 (char t to the right)

Household debt/liquid asset ratio

Source: Australian Bureau of Statistics

AUSTRALIAN HOUSING MARKET
Real housing prices Housing prices per GDP per head

Source: Steven Keen

AUSTRALIAN HOUSING POPPING?

Source: Steven Keen

AUD/USD
 Currently bouncing off of support around parity  1.07-1.08 should present significant resistance  I doubt AUD/USD will recover to new highs in the next few years  A breakdown below the channel support trendline (see next slide for chart) could catalyze much more selling  Below parity = game over  AUD/USD above parity may prove to be a generationally attractive short opportunity

AUD/USD

CHINA
 Re ba l a ncin g pe rm a n en tly a l te ring Ch i n a’s g row t h t ra j e c tor y i s a t h e m e pi c k ing up m o m entum a m o n g m a rket pa r t i c i pa nt s  Th e c o ppe r c ra s h c o ul d h ave s i gnific ant i m pa c t s o n ra m pa n t c o m m odit y c o l la teral fi n a n ce d c re di t s a n d t h e pe r t i n e nt ba n k c o un te rpa r t i es  CD S s pre a ds fo r Ch i n ese ba n k s h ave s pi ke d i n re c e n t we e k s  Ch i nese Oc to be r P M I c a m e i n a t a 5 0 . 4 pri n t ( a n aly sis i n fo l low ing s l ide)  A n ew t a x to h e l p fun d s o c i al s a fet y n et s i s l i kely g o i ng to l e a d to ex pa t ri a te l a bo r co s ts ri s i ng  A bi pa r t i s an bi l l i n t h e US Se n a te m ay a c t to m i t igate t h e e f fe c t s o f Ch i n ese t ra de po l ic y, w h i c h wo ul d be da m a g ing to g l o bal t ra de a s i t wo ul d s et o f f fur t h e r prote c t i o n ism  I n fl a t ion h a s e a s ed to a m i d - 5 h a n dle, but g row t h h a s be e n h i t s h a rply a s a re s ul t  Th e e a s ing o f i n fl ation co ul d s et t h e s t a g e fo r s o m e e a s ing , but I s us pe ct th i s wo ul d be t h e l a s t a t te m pt a s :
 In this event, inflation would rise right back, perhaps to new highs  The current growth slowdown is global and export growth would not offset the rise in inflation  China’s housing and overall fixed asset bubbles may be permanently popped

CHINA OCTOBER MANUFACTURING PMI
 October headline PMI print of 50.4 vs 51 .8 consensus vs 51 .2 prior  New Orders decreased to 50.5 from 51.3 prior  Inventory increased to 50.3 from 49.9 prior  Input Price decreased to 46.2 from 56.6 prior  New Export Orders decreased to 48.6 from 50.9 prior  Lowest PMI since early 2009  The seasonality factor in September’s strong PMI observed by Also Sprach Analyst seems to have been proven true with October’s weak report  The global growth slowdown is negatively impacting Chinese exports demand  China’s PMI has not been below 50 since February 2009

CHINA
 Real estate investment is driving 1 2% of Chinese GDP, up from 5% a decade ago and 9% in 2008  Whether or not inflation expectations become unanchored, PBoC will have to return to tightening by H1 201 2 to get real deposit rates back above 0, according to Nouriel Roubini  Weakening US & European consumer demand (already occurring) could lead to under whelming expor t figures going for ward  The Eurozone is China’s biggest trade par tner and peripher y austerity measures bode ver y poorly for external demand for Chinese goods  Allowing for sharper RMB appreciation may turn out to be the only way to successfully fight inflation, but this in turn will fur ther hur t Chinese net expor ts, and with investment finally being curbed, government expenditure would have to increase significantly or Chinese GDP would be at risk of slowing sharply  A new Bank of Japan repor t compares the current Chinese rebalancing to Japan’s in the 1970s with some alarming conclusi ons:
 The main factor behind the rebalancing was “decline on the return of capital”  Liberalization of bank lending rates occurred in Japan during the 70s and likely to occur in China in the 2010s

EMERGING MARKETS
 Hong Kong is teetering on the edge of recession (chart to right)  South Korea and Vietnam are seeing sharp slowdowns in export demand  India is getting hit hard by the European slowdown  India & Brazil have inverted yield curves
Source: Also Sprach Analyst

INDIAN INFLATION STILL RISING

Source: India Ministry of Labour

CITIGROUP ECONOMIC SURPRISE INDEX
 The Economic Surprise Index crossed below the zero line in late April, just as the market was topping  Since, it has recovered back to the zero line and implying bullish momentum  However, the Eurozone specific index is in sharply negative territor y  The US-specific index has climbed dramatically to almost 50, but whether this consumption-driven boost can be sustained remains to be seen
Source: Bloomberg

US BANKS
 US fins have come under a lot of stress lately  Balance sheet exposure to European govys is a primar y culprit  Declining net interest income has also been a bearish driver, especially now that the Fed is pancaking the yield cur ve (which should lead to even lower NII)  TLGP rolls could weigh heavily on bank capital ratios and expenses as interest expense rises  Large spike in maturities Q4 2011-Q2 201 2 (see char t to the right)
Source: Tim Backshall/Capital Context

STATE & LOCAL BUDGETS
 California revenue came in $1 .5 billion (6.5%) lower than expected year to date  This may trigger automatic spending cuts  If this becomes a more pervasive phenomenon, especially if the US recovery loses its legs, public sector employment may see sharp headwinds  Increasing social inequality and unrest is also a likely consequence of any austerity on the state & local level  States don’t have monopolies over currency issuance, like the federal government, as they are currency users

POLITICAL ENVIRONMENT
 Fiscal consolidation continues to be the name of the game in Western economies, exacerbating the underlying economic weaknesses in the non-government sector s  European leaders are seeing sharp declines in voter approval, as is Obama in the US  Jef frey Gundlach summarizes the 201 2 election per fectly, saying there are two par ties:  “Taxes are too damn low” party  “Spending is too damn high” party  Global geopolitics is becoming increasingly impor tant  Bin Laden’s death saw a resulting spike in terrorism in the Af-Pak region  Al-Awlaki’s death is likely to carry even more revenge risk, especially in Western nations and of homegrown varieties  The US war of words with Pakistan is escalating and could turn ugly if/when the US shuts off remaining funding and prohibits remittances (both of which are tactics being deliberated in a Congressional bill)  Israel and Iran are heating up their rhetoric against one another

2012: YEAR OF THE POWER VACUUM?
 The Arab Spring has resulted in power vacuums that entities like Al-Qaeda and the Muslim Brotherhood are trying to take advantage of  Europe is seeing a variety of administration shifts:
 Greece & Italy have seen their PMs resign  Germany’s Merkel is losing voter support and has lost her coalition  France’s Sarkozy is polling very poorly and set to lose reelection bid

 The US’s Obama continues to suf fer a high disapproval rating  In the current backdrop of a global growth slowdown and acute crisis in Europe, regionally and globally coordinated policy is paramount  This spells a lot of uncertainty and risk going forward, especially if exogenous crises manifest

DEFICIT SUPERCOMMITTEE
 The supercommittee is tasked with deciding on $1 .2 trillion in deficit reduction by the November 23 deadline  If no agreement is reached, automatic spending cuts kick in in January 2013  S&P has affirmed that a stalemate will not likely lead to another credit rating downgrade  If no agreement is reached, Congressional disapproval and voter polarization will only increase  The automatic spending cuts are designed to come half from defense and half from public programs  Government austerity remains the biggest threat to US growth, especially at this time  If the US economy starts faltering in Q4 2011 into early 2012, the prospects of austerity in the pipeline in 2013 will be a big damper on investor expectations

OCCUPY WALL STREET
 Occupy Wall Street appears to have three main focal issues:
 Corporate influence on democracy  Growing wealth disparities  Lack of legal repercussions in fallout of financial crisis

 The main fallout from OWS is that the status quo is increasingly seeing disapproval and systemic changes are being demanded  This negatively impacts both President Obama’s reelection hopes, as well as some of the more traditional GOP candidates  However, it does serve to boost Democratic Congressional approval (especially relative to GOP), as polls indicate  It serves to boost more radical candidates, as well as those who walk the line between the GOP & third party  Occupy Wall Street has gone global  97% of America’s “99%” a are part of the global 1% of top income earners

INCOME DISPARIT Y
 Th e a n n ua l US i n c o me s h a re o f t h e to p 1% o f Am e ri cans i s c o m ing o f f o f a 2 0 07 h i g h a ro un d 24 %  Th i s 24 % l evel wa s l a s t re a c h e d i n 1 9 2 8 , ri g h t be fo re t h e 1 9 2 9 c ra s h a n d e n s uin g G re a t D e pre ssion  Fi n a nc ializat ion o f t h e e c o n o my te n ds to i n cre ase i n co me di s pa rit ies  Th e s h a re o f t h e to p 1 % bot to m e d i n 1 971 , t h e ye a r N i xo n to o k t h e US o f f o f t h e g o l d s t a n da rd  Al t h o ugh a ret urn to t h e g o l d s ta n da rd m ay n ot be th e be s t c o ur s e o f a c t i o n , t h e l a c k o f c h e c ks a n d ba l a n c es to t h e Fe de ra l Re s e r ve’ s l i q uidit y ex te n s ions c o ul d h ave pl aye d a m a j or ro l e i n t h e c a pi t a l a l loc a tio n s h i f t s t h a t l e d to s uc h h i g h i n c o me di s pa rit ies

Source: Wikipedia

REQUIRED WORK HOURS TO BUY S&P

Source: The Chart Store

CONTACT ME
 I am a 21 year old recent university graduate who is always interested in receiving comments, insight, analysis, and commentary from market participants, observers, and reporters  As such, feel free to contact me via:
 Email: naufal.sanaullah@gmail.com  Twitter: @naufalsanaullah

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