CURRENCY/EQUITY ASSET PRICING CORRELATIONS PART I: JULY to AUGUST

Essential Nature of Asset Pricing Now and Over Months

Price action among assets have over months revealed euro and S&P to be positively correlated, while U.S. dollar moves opposite and is negatively correlated with euro and S&P. Last two trading sessions, however, are showing an odd break from these correlations.

Namely, as mentioned in last article, euro is in decline while S&P is up, and the U.S. dollar is up. Normally, where S&P goes up, one could expect euro to increase and dollar to decline. Stated otherwise, S&P is breaking from correlations to show risk appetite or a bullish sentiment. Euro and U.S. dollar are showing an opposite risk aversion or bearish sentiment.

Looking at past information that moved market price reveals fundamental influences on current asset class divergence today. Without knowing where you’ve been, how can you tell where you will go tomorrow.

July Market Activity Showed Considerable Disappointment, Except Exploratory ECB Comments  

Starting with the July to September period provides a reason for S&P recovering from its low of 1310 level in July. Going into September, S&P levels managed to reach 1470, which amounted to a multi-year high.

July 24 starts this period’s tail by knowing U.S. earnings season was in full bloom. This day marked a third day of 100+ point declines on the Dow Jones Industrial Average, with July 24 down 104 points to close at 12,617. U.S. dollar index was on a rip reaching 84.0, a high. Euro sunk like lead and saw a level below 1.2000.

Reason for S&P and euro declines and a U.S. dollar rise was Q2 earnings reports and renewed Greece problems magnifying Spain’s problems. On July 24 United Parcel Service, a strong bellwether, reported earnings and revenues that missed already reduced estimates and its stock fell 4.6%. Richmond Fed Manufacturing Index showed contraction and Reuters reported Greece would need another debt restructuring.

By July 25, things were looking up. Although Apple’s earnings were a surprising upset, Caterpillar and Boeing reported strong results. Still, sale of new houses reported a June gain of 350,000 when 369,000 was expected by economists. Also known was Spain’s borrowing level stood at an unsustainable 7.75%, German business confidence looked weak and Britain’s economy slumped for a third quarter.

Given these factors, equities closed mixed on July 25 with Dow up at 12,676, and S&P remained down, but only by a fraction.

Reason for July 25 avoiding a fourth day of deep equity losses appears to have come from Europe. While Caterpillar and Boeing looked good in Q2, ECB’s Edward Nowatny made a comment that bazooka power of European Stabilization Mechanism should be justifiably bolstered.

Such comments appeared to light a candle in darkness. ECB hadn’t yet announced their easing measures and Federal Reserve was “watching the economy closely”.

July 26 Activity Affirmed ECB’s Exploratory Comments and Renewed Equities, Euro and Took Stress off U.S. Dollar

July 26 sent a pitch to equity markets in the strike zone. Instead of rebuffing Edward Nowatny’s aggressive comments, ECB President Mario Draghi added to comments. Draghi made his politically charged comment that he would do whatever necessary to protect the Euro Zone. Consequently, Spanish yields retreated from threatening levels. Also helping were U.S. jobless claims coming in less than expected, durable goods beat expectations and where Exxon Mobile disappointed; 3M, Akamai Technology and Whole Foods Markets looked good.

July 26 saw Dow up an unimaginable 212 points, especially given previous trends on closings. Euro gapped up to just under 1.2280 from an abysmal 1.2100 space, U.S dollar took a steep loss into an 82.00 area from a near 84.00 area.

Nature of German and ECB Negotiations to Accomplish a Lasting Market Confidence Through August

ECB statements and some good earnings reports, against reduced earnings expectations, lit a firecracker under the back-side of equities. But more gunpowder was needed to push equities to recent year highs witnessed in September. Despite this gunpowder that would come, currencies stayed within range and correlations.

After July 26, on July 27, S&P made another grand advance, up a sharp 1.9% and Dow up 1.5% or 187 points to cross the 13,000 level, an obviously protected level today.

ECB remarks kicked of discussions among all European contributors, especially with Germany, which funds much of European activity.

Terms of ECB and German negotiation became defined by setting policy expectations in public spaces through exploratory comments. Markets affirmed the comments. ECB thereby gained a lead in negotiations, through placing market expectation “follow-through” on difficult countries that are deservedly difficult, due to imbalances.

Result was a real discussion of where to go, and by how much. Breaking a juggernaut.

Germany parlayed its stressed movement into limiting ECB.  Where ECB expressed open buying of bonds, the two agreed on Outright Market Transactions (OMT)….of buying bonds of countries to support debt pricing…..but only if and when a country asks for help….and thereby sacrifices fiscal sovereignty. It wasn’t until September that German/ECB negotiations resulted in a real policy.

Before German/ECB negotiations resulted in a September announcement, markets went into August with optimism, enhanced by Fed minutes.

Fiscal players in U.S. currently aren’t displaying similar alacrity in discussions as demonstrated by tough German and ECB negotiations.

Currencies Are Risk Off, Equities Are Risk On: A Divergence In Past Asset Performance

Last couple of days show asset classes acting in divergence from past market movement. Since summer of 2012, euro and S&P have traded almost in lock step….providing indications of sentiment. Trading in opposite correlation are U.S. dollars. Such positive euro and S&P correlations and its inverse, U.S. dollar, have not been numerically precise, but have moved with convincing consistency. These three assets have been so consistent; they’ve been market prophets due to all three moving in expected correlation.

Recently, the currency component of these three assets move according to last several months of history. Being when dollar goes up, euros go down. However, and also recently, equities aren't moving according to several months of predictability. S&P and Dow are moving up. Given dollar and euro currency movements, one would expect equities, or S&P and Dow, to go down. But they haven’t, in fact equities are increasing in value.

Equities are breaking from past correlation and rising from side way movement. Still, currencies trade according to months of performance. Currencies are seriously risk off with dollar up and euro down in notable terms. But equities assert a serious risk on look, by going up. Therein resides divergence in currency and equity assets. Equities are now outperforming past correlations with currencies. Why.... is the question now.

Currencies are tied to fundamental country performance….essentially a country’s economic indicators and domestic ability to show wealth…as in consumption, inflation and debt. Equities are tied to  fundamental capacity of companies to increase revenue firstly. Depending on ability of management, revenues are theoretically converted into earnings, boosting shareholder value.

Looking at recent movement in equities against currencies, such divergence doesn't appear to be justified by fundamentals . That is, equity markets or company earnings and revenues don't look that much better versus issues countries are confronting. Conversely, equity markets might be seeing optimism in coming country or company performance. 

Reason for optimism seems remarkably clouded now. Clouds right now come especially from prospects of fiscal solutions in the U.S., and whether the Federal Reserve will expand QE3. 

Fundamentals for both currencies and equities remain challenged after economic indicators and company earnings reports are considered.  

Public Domain Software: Pain From Intellectual Property To Electronic Retailer

Technology is seeing Trending Price Deterioration

Essential problem confronting technology companies, especially original equipment manufacturers, is a price deterioration of product. Anecdotally, if one prices an electronic item at a wholesaler, then looks at same item on a major internet retailer such as E-Bay for instance, a level of price competition can be witnessed. What is disturbing, however, are increasing frequencies when same item will show up at impossibly deep discounts.

Ramification of this effect across supply and distribution chains disrupt business planning prospects from memory suppliers to electronic retailers. This effect has been witnessed for years in memory markets and lower value added electronics. Now, it occurs in tablets, smartphones and equipment in general. Operating system associated with these lower priced products often times is Android.

Lost Value in Intellectual Property, along with Supply and Distribution Chains

Protecting product pricing typically comes from retaining control over intellectual property rights, while also managing business chains. Firstly supply chains need to be managed to prevent outsourced manufacturers robbing technology. Secondly, distribution chains need an ability to show pricing discipline to prevent flooding markets and price declines.

However, first attack to this model is putting intellectual property into the public domain for innovation and new discovery. Android and WebOS are primary examples. Where Android did not involve a deep upfront investment by a single company, WebOS was held by Palm, bought by Hewlett Packard for $1B. Now it’s given to public collaborative development.

WebOS was the intellectual property backing future propositions for Palm. Hewlett Packard’s justification for buying Palm was moving Palm’s technology into currently competitive products. Now WebOS is in the public collaborative space, as opposed to Hewlett Packard’s portfolio of intellectual property.

Apple once had a very unique product. Now Android finds its way into various products sold by various companies. Some of these companies look for market share by defining their products with cheap pricing. Defining a company by distinguishing your products with cheapest price is a losing proposition.

Strength is in Maintaining an “Ecosystem” of Integrated Products that Improve User Experience Across all Products

Apple’s major strength today is their “ecosystem” of products. Which basically equates to intellectually protected products (outside of Samsung’s win, loss or draw) a protected supply chain (again outside of Samsung issues) and a distribution chain that is so far exemplar in sustaining price strength.

Apple’s other major strength is its integrated products which not only communicate with each other, but do so in a synergistic way. For example, seeing your phone on your living room TV set….at least should you be so inclined. And a new Apple TV system is expected.

Android teaches that once intellectual property is released to the public domain, intellectual property value deteriorates for any one company. Result appears that many companies compete against each other for fast deployment of existing technology. A race then occurs to cheapest pricing. Winner in this model becomes the company that adapts new technological creation into equipment production on the cheap. Rising labor costs in China can be a limiting factor, but other ASEAN countries?  

Japan’s Efforts to Avoid Recession, Comparison With Central Bank Activity and Focused Easing

Bank of Japan’s Expansion of Easing and Bank Funding, With other Central Banks

Japan’s economic indicators are showing weakness and expectation is Japan entering recession in Q4. Where European Union has slipped into technical recession, Japan seems next. Company revenues generally disappointed in Q3, though analysts moderated their projections through the quarter. In Q3, analysts also moderated their earnings projections. With revenue disappointing, considerable declines in earnings could be realized.

Real question is what catalysts exist to prevent recession in Japan and sustain demand, and therefore sales.

Countering Japan’s economic numbers are efforts of Bank of Japan. In September, Bank of Japan (BOJ) announced a 10T (Trillion) yen increase in its already existing asset purchase program, raising total easing purchases to a projected 80T yen.

This announcement was relatively concurrent with U.S. Fed’s September QE3 announcement consisting of $40B/month in mortgage backed security (MBS) purchases. European Central Bank also announced their Outright Monetary Transactions (OMT), which cooled Spanish and Italian yields.

Bank of Japan took further steps in October by raising their easing programs another 11T yen, to a total 91T yen. Where U.S. QE3 remains stable and ECB’s OMT remains untapped so far, BOJ is expanding their asset purchases.

Not only does BOJ have an expanding asset purchase program, but also exceptional funding for banks, similar to United Kingdom. BOJ has ear marked 66T yen for asset purchases and 25T yen for bank funding to promote lending.

BOJ’s Asset Purchasing Projections, Japan Market Responses and Other Central Banks

For BOJ’s asset purchasing, it is a diverse program which involves risky assets. According to BOJ’s description of its asset program, the bank has 39T yen earmarked for Japanese government bonds, not unusual. They have 19.5T yen reserved for Treasury Discount Bills, again not unusual.

What is of note, and according to BOJ information, bank is putting 3.2T into commercial paper. 2.1T into exchange traded funds (ETF’s) and .13T into equity issued by real estate investment corporations. Appears BOJ is taking equity stakes.

Interesting for BOJ’s approach is when they announced their enhanced easing in October, Japan’s major stock index, Nikkei 225, fell 1%. Of course concurrent worries of territorial disputes with China existed as with European issues. Still, long term prospects for BOJ’s balance sheet perhaps raised concern.

Contrasting is U.S. QE, which so far remains constricted to MBS’s. Also is ECB’s OMT’s, which remains confined to sovereign bonds of a country requesting assistance. It appears Spain has not made a request most likely out of protection of its sovereignty. Recent Catalonia elections, however, could force matters.

BOJ’s Measures to Promote Bank Lending, Covering Natural Disaster

BOJ also has two bank funding plans. Firstly is its “Growth Supporting Funding Facility” of 5.5T yen, increased in March by 2T yen and currently tapped at 3.4T yen. Then is BOJ’s loan promotion called “Stimulate Bank Lending Facility”, of some 19.5T yen.

Growth Supporting Funding Facility looks to be a rebuilding effort in Japan’s tsunami and earthquake devastates areas. Starting at 2.1T yen, BOJ announced in March an increase of 3.4T yen to a total of 5.5 T yen. BOJ Governor Shirakawa also announced relaxing program restrictions in order to reach smaller lenders and promotion of access to loans for medical providers. Loans under this program look to be .1% and require application review.

When this announcement was made in March, Japan stocks fell and yen rose against U.S. dollar. Apparent was market disappointment in BOJ not announcing other easing measures. But added easing certainly came in September and October.

Promoting Bank Lending on an Organic Basis, Like BOE’s Similar Efforts: Results Awaiting

Next bank funding mechanism for Japan is its “Stimulate Bank Lending Facility” announced in October. This facility appears to have 19.5T yen of ammunition (though “unlimited”) and is a funding facility tied to net bank loans. Much like BOE’s “Funding For Lending Plan”.

BOJ’s Stimulate Bank Lending Facility grows out of what Governor Shirakawa expressed in his November 12 speech in Tokyo. He said “The bank hears from many corporate managers that there are only a few attractive investment opportunities at home.”  Explaining cause for a proposed solution, Shirakawa offered, “Unless we somehow manage to change this view, it will be difficult to stimulate business investment.”

Program details appear rare. Still based on BOJ documents, it is tied to net Japanese bank lending, can be yen or foreign currency denominated.

Analogous is BOE’s Funding for Lending Plan, which started in August and is a collateral swap program. British commercial banks swap their previously authorized collateral for United Kingdom treasuries. Values of U.K. treasuries a bank may swap are tied to amount of new lending the bank undertakes prior to program expiration. Enforcing the program is a penalty fee imposed on a bank should their net lending fall below a baseline.

 

For England, and yet to be known by Japan, is British Banker’s Association reporting progressing increases in mortgage lending, and in the period of October over September. BOE is, however, saying that it is too early in program progress to know actual effects.

 

Currently, it looks that new easing measures among countries are becoming much more directed and focused on particularly weak areas. This contrasts with previous easing that generally tended to flood markets with cash. More precise measures looks to focus liquidity in a manner that increases direct investment demand and employment.  

European Union In Recession, Japan Recession Looks Next

Company Revenue Declines Reflect Progressing Global Slowing

Preliminary U.S. GDP numbers will be announced Thursday with current consensus range being 2.8% to 2.9%. Such numbers seem ambitious given earnings season results. Where over 70% of companies reported earnings above expectations, a startling 60% disappointed on revenues. This marks the lowest beat rate on revenues since Q1, 2009, according to Factset.

Earnings can be made to look good by shifting accruals and creating efficiencies. Revenues are sales and they either exist or they don’t. Through revenues, one gains insight into fundamental demand.

Europe is an obvious explanation for apparent demand weakness. Europe also appears to be trending into added weakness.

Europe is now in recession with two straight quarters of GDP contraction. Most recent Q3 data shows a EU -.1% GDP contraction. This combines with a Q2 contraction of -.2%. Most concerning is Germany, EU’s chief financier. On November 23, Germany reported quarter over quarter GDP decline from Q2 growth of .3% to Q3 growth of .2%. Year over year, Germany’s GDP growth went from 1% in Q2 to .9% for Q3. More concurrent industrial production numbers show German production contracting -2.1% in October.

Japan Q3 GDP Contracts Sharply, Against Its High Sovereign Debt

Projections are next for Japan to fall into recession. Q3 results show Japan’s GDP declined a marked -3.5% versus Q3 2011, its largest contraction since March 2011’s tsunami strike.

Of Japan’s GDP, a cut of .7% came from faltering exports. A concerning feature given Japan’s declining Terms of Trade recently discussed on this space and its implications for Japan to sustain its debt, which ranges 220% of GDP. Highest among G7 countries.

Private capital investment, on the GDP report, saw caution assert with a decline of -3.2% versus Q2.

Japan’s Exports Continue Into Weakness, Now Imports Look To Further Weaken

Troubling for Japanese exports is an ongoing dispute with China over what Japan calls the Senkaku islands (China calls them Diaoyu islands). Consensus is this dispute now creates an outsized impact on trade between China and Japan. China is Japan’s largest trading partner accounting for 20% of Japan’s exports in 2011 compared with U.S. buying 15.3% according to Japan External Trade Organization numbers.

On November 20, Japan reported its merchandise trade results for October. This data reveals balances between exports and imports. According to data, Japan showed a steeper than expected trade deficit of -549B yen, expectation was for a -337B yen deficit. More troubling for global demand is Japan’s exports contracted by -6.5% in October, and its imports also contracted some -1.6%.

Exports for Japan are now down for a 5^th consecutive month, but exports to U.S. have been positive for 12 month and up 3.1% for October. Perhaps demonstrating U.S. decoupling from general global weakness (despite a strong yen). Still, creating real concern for U.S. is Japan’s negative import number of -1.6%, first time in only two months, indicating volatility looking to trend into weakness.

Deflation Marks Japan’s PPI, Japan And China Show Major Weakness In Steel Prices

Released November 11 was Japan’s CGPI (corporate goods price index) which is akin to a producer price index (PPI) and monitors price inflation, or deflation. October price results show deflation in Japan with producer prices falling -.3% month over month and -1.0% year over year. This index is trending into deflation with October bringing a 7^th consecutive monthly decline.

For particular businesses, weakening is most noted in electronics at -3.6% and lumber -3.4%. But what really shows weakness is iron and steel prices down a concerning -9.9%.

Declining steel pricing in Japan combines with a similar result from China’s PPI (released November 8). China’s PPI showed ferrous metals down 11.4% for October, after contracting 12% in September.  

Looking at other economic indicators for Japan, none  point to positive results. General propositions suggest Japan entering recession. However, Bank of Japan has been hard at work with a variety of programs, which includes a very diverse asset purchase program that’s been growing.

Recent Fiscal Talk Meets Declining Company Revenues: Cost of Capital

Widening Credit Spreads Are Supported By Declines In Company Financials

Of notice are current credit spread increases associated with serious winds out of Europe and other matters. Currently, credit spreads are increasing in recognizable terms. Such increases can be noise, or a real deal on market moves. Due to last quarter's moves in fundamental financial performance of companies, namely disappointing sales results, widening spreads aren't surprising. Credit spreads, company sales and sovereign debt all appear correlated.

Credit spreads have been in a condition of widening since October. But over the last few trading sessions, spreads have been moderating. Encouraging in this regard are optimistic market responses brought by politicians addressing U.S. fiscal issues. Because fiscal approaches right now are nascent and undefined, strong market responses seem a little irrational.

Fiscal Talk Starts An Economic Anchor, But For Fundamental Conditions To Improve, The Anchor Must be real  

Where central banks have held the dike, giant leaks are showing not necessarily in company earnings, but in sales, and cash flow. Inevitably declines in revenue and cash flow can appear in considerable earnings disappointment. We are seeing this progressing weakness in most recent reports on earnings.

Company revenue and cash flow issues certainly threaten investor expectations of increased dividends and share buy backs, let alone capacity for fundamental or organic growth. Despite very low interest rates, when declines in revenue are experienced, cost of capital for companies increase especially on the equity side.

Increased cost of capital diverts management's attention to transitioning into cheaper capital, being debt currently given low growth prospects longer term. Cost of debt needs to stay stable. Stability in this area should enhance return rates, confidence and make equity pay. Equity pays only with higher rates of organic business growth. 

Equity comes with increased risk over prioritized debt.

Company Revenues Take Time, Political News Cycles Occur Overnight

What took time to develop was company weakness in revenues and cash flow. What hasn't taken time is  lots of optimistic buying due to fiscal lip service. Company financial statement fundamentals remain necessary for business function, let alone equity growth.

U.S. has an interest rate on its debt not deserved by its fiscal situation. A Q4 question is whether equity prices are reaching a similarly undeserved level, given increased prices of equity due to declining fundamental growth.

Worry exists that news cycle flashes will only create an illusory solution. Should markets respond on illusory lip service....too much encouragement grants a license for continued talk.

U.S. Has a Debt Issue, Compounding is Japan's Debt Issue

Debt Presses Europe, Now U.S., Next Japan

Obvious new dynamics are occurring in highly developed countries. Debt issues are progressing beyond capacity for easy resolution and grow to become a mirror that fiscal policy leaders do not want to see. Also obvious is progression of this dynamic moving from Europe into U.S. Next will be Japan.

Japan is unique in that most of their debt is domestically financed, as opposed to foreign investment. But, for Japan, a shrinking global economy bodes that their ability to domestically finance debt will also shrink congruent with slowed global growth.

On November 8, Japan's finance ministry reported a current account deficit for September. First time in 30 years. Japan's terms of trade (a ratio of export prices against import prices) has been in deterioration as value from exports wane against costs of imports. From 1960 through 2012, terms of trade for Japan have averaged 174.56. In August, 2012, Bank of Japan said the number stood at 90.50.

Based on more concurrent indicators, terms of trade numbers aren't improving for Japan.

Where Europe has managed to kick a can down a blind road, chances for other countries, namely the U.S. and longer term Japan, to perform in like manner diminish. Perhaps significantly. All due to progressing global weakness.

Hope of economic growth increasing government revenue to offset debt not only is looking bleak, but government debt is too large for realistic growth rates creating a meaningful offset on debt.  Austerity can't be avoided. Still, austerity's reach needs to be balanced, to avoid strangling growth. Historical analogies don’t really exist, certainly in an integrated global economy.

What is known, U.S. Congress needs to look more adult and less childish. Winning political party battles on scorched earth efforts, leaves a scorched America.