Sooner or later it was bound to happen. Having disappointed the markets for four straight months in a row, the US payroll report on Friday finally produced a decently robust gain of 163,000, which was much better than the consensus expectation for about 100,000. The market reaction was immediate and powerful. The S&P 500 surged 1.9%, one of its best days of the year, and appropriately enough returned to 1,390 which was exactly the level it hit just before dismal payroll figures in April and May signalled the US soft patch. Meanwhile, the US Treasury bond futures fell by two full points. Of course, a single good payroll number does not mean that the US economic slowdown is over and Friday’s report offered caveats.
1) Payrolls are volatile and heavily revised, although Friday’s figure was more credible than usual as it was exactly in line with the less volatile ADP survey.
2) Household employment remains weaker than the payroll survey, with gains averaging 118,000 over the past three months. This resulted in a higher unemployment rate, which may not be statistically meaningful but will do little to boost consumer confidence.
3) Most other growth data remains quite weak (national and most regional ISM surveys), with the crucial exception of housing, where improvements in both activity and prices are now undeniable.
Despite these uncertainties, which will only be resolved with the passage of time and the release of more statistics, we are firmly convinced that signs of better growth in the US – and also in China – have been the main driver behind the recent improvement in global equity markets, and the corresponding setbacks in bonds and that this pattern will continue in the coming months.
The fact that the global economy is driven first and foremost by events in America, and secondarily by China may seem so obvious it is not worth stating. Yet time and again we hear from our clients and read in the media that news from Europe is driving the markets. On Saturday, for example, this is how the FT began its front-page story “Stock markets rallied yesterday as Spain responded to a conditional offer of intervention from the ECB” and did not mention the US jobs data until the third paragraph. Did investors suddenly fall in love with the ECB’s non-existent plan on Friday morning, after (justifiably) dismissing it the day before? This is a ridiculous idea. As long as the euro crisis rumbles on, with little chance of either resolution or breakup, stock market trends will continue to driven almost entirely by events in the US and China, with Europe acting as little more than a sideshow.
To be more precise, because the euro can neither be fixed nor abandoned, at least in the next six months or so, Europe will continue to create lots of short-term volatility, but will not drive any sustainable trends, either up or down. Those trends will be determined by events in the US and China. And the good news is that the US and Chinese outlook now seems to be improving, albeit slowly. As long as this remains the case, the best investment strategy will be to increase exposure to equities, credit and other risk-assets, while cutting back on overvalued “risk-free” bonds.
To limit short-term volatility created by the never-ending euro crisis, the best hedge is probably the simplest – a short position in the euro against the dollar. The euro’s knee jerk strengthening after the payroll report was the usual short-covering rally, but we see no correlation between the euro and equities. Since we started recommending this strategy of long-equity/short-euro strategy last September, it has performed well – eliminating most volatility while delivering the full return available from the US and global stock markets. With luck, this pattern will continue in the months ahead.
Should any reader of RedBlog be interested in receiving GaveKal Research on a free trial please contact firstname.lastname@example.org