As we had expected Initial Claims data rebounded higher from last week's very low print of 330K and although this week's report of 368K was worse than expectations of 350K, the lack of a revision to last week's number is quite significant. The effect on the 4 week ma was to nudge it higher to 352K, but this series has a decent chance of breaching the magical 350K level next week since a relatively high 375K print from January 4th will drop out of the data. Overall January's data suggests that Claims data continues to improve, meaning that lay-off pressure has abated in recent months.

None of this matters much if the more widely followed (but no more accurate) BLS Non-Farm data does not mimic this improvement tomorrow. It is interesting that Private Sector payroll growth has not budged from the 160K (when measured as a 12 month ma) for the last 18 months, during which period the 4 week average of claims has fallen from around 430K to 350K. A drop in claims of this magnitude would generally imply a significant improvement in Private sector job gains, and while we do believe that hiring plans have been more depressed than normal this cycle (largely thanks to regulatory pressures and uncertainty) this divergence in the two measures is still a major statistical puzzle. Our bias is towards Claims (not least because they confirm our own subjective beliefs), but we recognize that financial markets and the central bank are much more influenced by the NFP report.

The production of economic statistics is an arcane process which has the tendency to throw out some significant surprises and we were reminded of this today when the US Personal Income data showed an estimate surge in income of 2.6% in December 2012. Although we do believe that incomes were boosted to some extent by accelerated dividends from both private and public sector companies, together with early bonus payments for higher paid employees (both caused by the correct belief that dividend and income taxes would increase in 2013 for higher income individuals) it is likely that December's data overstates the improvement for the month by a considerable margin.

Indeed going back to 1990 there are three other examples of "upside outliers" December 1992 (3.4%), December 1993 (3.4%) and December 2004 (3.3%). We doubt it is a coincidence that the same calendar month was involved on each occasion, and each was followed by a significant negative month in January (-3.7%, -2.8% and -2.3%). Unfortunately we imagine that the same pattern will emerge next month, which would mean that the two months will have to be considered in unison. Of course if January's data does not involve a large draw-down then this would suggest that the December data involved some significant catching up of the data series with prior improvements, which would be a much more positive scenario.

Link to text:
http://www.federalreserve.gov/newsevents/press/monetary/20130130a.htm

The FOMC statement for January 2013 suggests that the Committee has continued to fine tune the boundaries of what we have termed the "Bernanke Doctrine". Although this could be seen to be an extension of prior bouts of Quantitative and Credit easings, we have argued that the decision to start targeting a level of unemployment via expansion of the FRB's balance sheet is a radical change in policy that has fundamentally changed the role of the FRB going forwards.

We have never understood the point of pouring over GDP reports when the data is simply too "large" and nebulous to be of much use for understanding where opportunity and risk resides in a marketplace. This is particularly true when Private sector and Public sector expenditure move in opposite directions, as was the case in Q4 2012, since the net result can be very misleading.

The headline report showed Real US GDP to have shrunk by -0.1% compared to expected growth of 1.1%. However, the shadow of the Fiscal Cliff loomed over the data with total Federal spending dropping -6.6% on an annualized basis and the sub-category of Defense being slashed by -22.2%. Much as we would love to have turned the corner on the bloated Federal expenditure Q4 clearly saw some accounting shenanigans, which presumably created some space for the Treasury to operate in the event that the Fiscal Cliff and/or Debt Ceiling came into effect. We would expect these measures to be reversed either in Q1 or Q2 2013, with a corresponding boost to the data.

Meanwhile Personal Consumption, the largest category of GDP, grew by 2.2% in real terms, just ahead of expectations, suggesting no slowdown in the steady recovery of this key portion of the economy. Some much better news was delivered by Residential Construction, which grew 15.3% and Investments in Equipment and Software, which grew 12.4%. Both of these are obviously important metrics for actual corporate activity (although we prefer to use actual sales data reported by public companies, which also look to be robust for Q4 2012).

A glance at the attached chart will show that the performance of these sub categories in Q4 2012 is the exact reverse of that seen during late 2008/early 2009. Four years ago Private sector activity was collapsing (led by Residential Construction) while the Public sector was increasing rapidly. This morning's GDP report was therefore not only quantitatively different (being a much milder drawdown) it was also qualitatively so.

From our perspective the ADP Payroll report has gone down several notches since its methodology was revised last year (we far preferred it before its methodology was massaged to attempt to bring it close to the BLS report) but it is still worth monitoring as secondary data. January's report estimated 192K job gains, well above consensus of 165K, but this was compensated for by a downward revision of December's data from 215K to 185K. The trailing 12 month ma moved lower to 141.9K, but it should be noted that the data for the mid portion of 2012 was revised very heavily lower when the new methodology was rolled out last year and the last 4 months have seen an average of 177K jobs added, which is perhaps a better guide to the level of the index.

With employment data now holding the whipping hand over FOMC policy, and the FOMC publishing its rate decision this afternoon, today's report will have given another "upside nudge" to those who believe that the "Bernanke Doctrine" may have become overextended at the current time, although no doubt the slippage of GDP growth back into negative territory (which strikes us as nothing more than a statistical fluke caused primarily by a timing of defense spending) will give the dovish majority plenty of material to push back with.

Weblink for non-terminal users:
http://www.bloomberg.com/video/amazon-s-bezos-a-broad-thinker-auletta-says-YQpreHNLRNOMnQAzc6f_RA.html

A very interesting interview with the author of "Googled" regarding the changing relationship between content and technology. This remains one of the more important "side stories" of the current economic cycle and it is particularly interesting that we are starting to see a recognition that the value of content is starting to be increased.

Tuesday morning sees the release of the weekly report on the ECB's balance sheet and we will therefore take the opportunity to publish a "maintenance chart" which updates the state of affairs at the ECB and FRB for our readers.

We started tracking these two banks together during the Eurocrisis, when we argued that the ECB would be forced to follow in the FRB's footsteps and enlarge its balance sheet. In the event, the Trichet-led ECB waited until the summer of 2011 to start a "silent reflation" (the ECB's balance sheet ex-gold rose from €1.54 trln in April 2011 to €1.86 trln at the end of September 2011), and it took a change of leadership and a great deal more turmoil until the LTRO was introduced at the end of 2012.

Under the LTRO, the ECB saw its assets balloon to a high of €2.668 trln at the end of June 2012, but since this time there has been a substantial run-off of liquidity. Indeed the balance sheet has fallen in each of the last 7 months reaching €2.49 trn at the end of January. It should also take another sharp dive lower following the announcement this week that €137 bln of LTRO funds will be voluntarily repaid by European banks (since the ECB deposit rate is zero they have no incentive to hoard cash at the ECB, unlike banks using the FRB deposit facility who still receive 25 bp per annum on excess reserves).

Therefore although the 52 week measure of ECB liquidity provision is still +€230 bln, we anticipate this measure moving into negative territory perhaps by the end of the first quarter. At the present time this draining of liquidity gives us little cause for concern, but it is a trend worth watching since it is likely to be a force behind local safe haven bond yields moving higher.

Meanwhile the FRB is held under the trance of the "Bernanke Doctrine" (under which the balance sheet of a central bank is utilized to target specific economic goals), and we have started to see the FRB's balance sheet move sharply higher. This spike in assets took somewhat longer to appear under QE3 than its predecessors due to the fact that MBS credit was being exclusively targeted during the first 3 months, and this has a multi-month settlement period. Last week saw assets increase by $45 bln, taking the 52 week measure up to +$70 bln. We would expect to see this measure move sharply higher as the FRB implements its current policy.

Although this may appear to be good news for US fixed income markets, readers should note that January 2013 is the first time since the bull market started in 2009 that a sharp equity rally has left all credit markets trailing in its wake. It is our belief that QE3 is not only unneeded from an economic perspective and misguided from a theoretical one, but its beneficiary is much more likely to be US equities than fixed income going forwards.

In a widely anticipated move, the RBI cut the Indian REPO cut-off rate by 25 bp to 7.75% this morning and also trimmed the reserve requirement to 4.00%. The local equity market had already discounted this move and the SENSEX fell approximately -0.5% to close just below the key 20,000 level. While the of these two moves the drop in interest rates would seem to be the more important, since India's reserve requirement was already at a historic low prior to this announcement although banking liquidity remained tight with large daily cash injections being required in recent weeks (see lower chart). The interest rate cut was in line with majority consensus but some were hoping for a larger cut of 0.50%, which certainly would have been justified in terms of the slippage in local economic activity. However, as we have pointed out several times in recent months, the RBI is struggling to balance helping maintain GDP growth over 5% with problematic inflation still in high single digits, fiscal deficit and trade deficit, both of which exceed 5% and a weak currency, which fell to an all time low in 2012. As most readers are aware we do not believe that the RBI will be able to navigate its way through this series of economic obstacles without significant volatility in local asset markets.

Interestingly of these issues, the RBI emphasized the trade deficit as its primary concern (it was politically astute to pick the fiscal deficit as its target). It should be noted that while India's largest driver of imports is energy (which is unlikely to be subject to further tariffs given its economic importance) the biggest controllable item would seem to be gold imports. These have already been addressed this month by an increase in the gold import tax, but it would seem that further measures will be required to really dampen India's demand for the physical metal. This should be a source of concern for all investors with significant exposure to the metal since Indian demand has been a key driver of the 12 year bull market.

The US Pending Home Sales report has caused a moment of self-doubt for the market this morning, but a considered reading of the report uncovers little cause for concern. The headline Pending Home Sales index fell to 101.7 (January 2001 = 100) in December from 106.3 in November and while this may seem like a large shortfall it is actually fairly typical for this index to bounce around from month to month. As can be seen on the attached chart, the index remains in a strong uptrend and December's reading was still 6.6 points higher than that of a year ago. The 12 month ma of sales has risen to 100.4 and if we exclude the tax-credit stimulus of 2010 this is the first time that average 12 month sales have been above "normal" since September 2007.

Furthermore December is by far the quietest month for the underlying data, as can be seen on the NSA chart that is attached, meaning that relatively small changes in estimated sales have a magnified effect in the headline report (which is seasonally adjusted). December's NSA reading was 66.9, 3.1 points (4.9%) higher than December 2011 and the highest December reading since 2006. In summary, nothing in this morning's report should be taken as evidence that the US housing market is not in full recovery, although we can understand why an overstretched market has found the data hard to digest over the short term.

Regular readers will be aware that we view Consumer Confidence as a useful contrary indicator once it reaches extremes, and this is doubly so when the local equity market performance diverges at the time the extreme is recorded. Therefore we take a sanguine view of the fact that Italy's Consumer Confidence index fell to a new all time low in January of 84.6, exceeding the November 2012 reading by a whisker.

Italy's equity market (FTSEMIB Index) on the other hand is the 11th best performing global market in 2013, up 9.51%. Of the 10 markets ahead of it only Switzerland's SMI index (up 9.68%) counts as a true developed market with equivalent depth and capitalization. Over the last 6 months Italy is the 9th best performing market, up 31.02%, and only Spain's IBEX (+31.61%) could be fairly compared. Of course Italy's market remains at a historically depressed level, and although it is 44% higher than its July 30th all time low at 12,295, it remains well below its October 2009 recovery high of 24,558 let alone its last cycle high of 44,364 recorded in May 2007.

This helps explain how Italian consumers can feel as bad as they do while the equity market posts heady gains. Sooner or later this divergence will narrow, but the odds are that it will be a surge in confidence rather than a collapse in the equity market that restores some balance.

Brazil's CAGED Job Creation Index is the equivalent of the US Non-Farm Payroll report (although it generates a fraction of the attention of the latter). As we have been reporting for a number of months it has shown a marked deterioration of local job creation. December was no exception with a total of -496.9K jobs created (i.e. lost) during the months.

Even though December is always a negative month (the data is not seasonally adjusted) this was still a much worse figure than had been anticipated (consensus was for -401K). It is also -88.9K below the level of December 2011 and is the 2nd worst month on record (after December 2011). It brings the trailing 12 month ma of job gains down to 72K, compared to a level of 131K in December 2011. Despite the claims of the government that economic activity had started to pick up towards the end of the year, there is no sign of this in employment data, which is on trend to fall below 50K per month by mid 2013. Any further deterioration in trend would actually suggest that Brazil starts to lose jobs going forwards.

US New Home Sales were estimated by the Census Bureau to be 369K, somewhat below consensus expectations of 385K. However, this shortfall was made up for by a large revision in November's data from 377K to 398K. Readers should be aware that the Census Bureau's arcane process leads to particularly volatile data in the winter months, when relatively small fluctuations in their measurements lead to a large swing in the seasonally adjusted headline number.

Moreover, we have a substantial number of data points from public home builders that suggest that Q4 2012 saw another leg higher for new home sales, and this is also suggested by the wider NAHB sentiment survey (that covers a large number of smaller private builders as well as the large public companies), which broke out to cycle new highs in November and stayed there in December. We therefore believe that Census Bureau sales are probably missing a portion of this improvement, which would come as little surprise given that they rely a great deal on guesswork rather than actual measurement.

Interestingly the equity market has chosen to follow the lead of actual reported sales, and the level of the S15HOME index is now back to a little over 50% of its July 2005 level, whereas the official New Home Sales and Permit data are currently at 30% and 35% of their July 2005 values. Regarding which of these measurements proves to be correct we will have to wait until the key spring selling season is underway, but given the highly cyclical nature of the home-building industry and the very long period in which activity has been at muted levels, we would expect to see a stronger rebound that has currently been captured by the official data.

Brazilian loan issuance continues to be dominated by State Owned banks while the Private Sector has restricted credit growth significantly in recen months. December's data showed total credit growth of 54 bln BRL (2.37%), of which State banks were responsible for 41 bln (an massive increase of 3.82% of total outstanding loans) and Private sector banks 13 bln (1.09% growth).

This means that for 2012 as a whole total Financial System Loans grew by 329 bln BRL (16.22%) to reach 2,359 bln. This compares to a total of 1,227 bln at the end of 2008, meaning loans have approximately doubled over this period. Private Sector loans grew by 89 bln BRL in 2012, a growth rate of 7.86%, which was almost exactly half that of the the growth rate of 2011. Total Private Sector loans outstanding have reached 1,233 bln BRL, compared to 778 bln BRL in December 2008 (a 58% increase over this period). State banks ballooned their loans outstanding by 239 bln in 2012, or 27% to 1,125 bln BRL. In December 2008 they has a mere 448 bln BRL of outstanding loans meaning that their exposure is now 2½ times greater than they were 4 years ago. We very much doubt if this pace of increase can have taken place without a substantial negative impact on underwriting standards.

At the current pace of increase the State sector should become the dominant provider of Brazilian credit some time in early 2013, which would be an apt financial metaphor for the way that the government has re-exerted control over the local economy. Needless to say we do not expect this episode to end well, particularly since the spurt of Private Sector credit granting in 2009 and 2010 has already led to an elevated default rate in Personal loans (this rose back up to 7.9% in December). Furthermore there is little sign that the massive increase in credit issued has had much of a positive effect on local economic activity, although perhaps we would have seen a sharper slowdown in personal and business spending if it had not been for the largess of the State sector banks.

US Initial Claims data continues to exceed expectations, with this week's level of Claims reaching 300K, well below consensus expectations of 355K, and no upward revision to last week's very low print of 335K. However, the fact that we are still dealing with the notoriously tricky January period (when the divergence between seasonally adjusted and raw data is at its greatest) and also the Martin Luther King holiday means that we still have to take this very encouraging data with a pinch of salt.

However, this does not mean that it should simply be ignored, and the fall of the 4 week average of claims to 351.8K has taken this indicator down to its lowest level since March 2008. Although we have seen some reports comparing the seasonal dip in January 2008 to that of 2013, it should be recalled that 5 years ago there was already clear evidence that Claims were in a rising trend, and that the local economy was in deep distress (a fact the FOMC was completely blind to at the time). This hardly describes the state of affairs in 2013, and although we are prepared to see a bounce in Claims from the current level, we think that the clear improvement in trend deserves respect.

Recent weeks have seen a marked divergence between the performance of India's large cap SENSEX index (which tracks 30 of its largest companies) and that of the BSESMCAP which follows 515 of the country's smallest companies. Generally the relationship between these two indexes is fairly close, with the latter being a much higher beta version of the former, but the rally that took place in the second half of 2012 strongly favored the larger cap SENSEX and left the BSESMCAP trailing in its wake.

2013 has seen a continuance of this divergence, for while the SENSEX has marked time after being halted by key resistance at the 20,000 level, the BSESMCAP has broken down in recent days and is now -8% below its January 7th peak of 7696. The index has already violated its uptrend at the 50 day ma (currently 7351) and is testing what looks to be key support around the 7000 level.

Our concern is that the BSESMCAP may actually be the better gauge of Indian economic conditions at present, since it is far less influenced by foreign investor flows, which have been at record levels in recent months. Indeed YTD these already total $3.014 bln, a milestone that took until February 15th in 2012 and March 17th in 2010 (the two strongest years for Q1 flows prior to 2013). Frankly we can see no justification for this enthusiasm in either India's economic or corporate data, and it appears to be a clear example of higher prices and higher demand feeding off one another.

The other factor to bear in mind is that small cap companies do not enjoy the same easy access to the bond market that the SENSEX members do. It is our belief that corporate bond issuance has been a key moderator of tight local monetary conditions in many emerging markets, but particularly India, where general liquidity still appears to be very tight.

Daily cash injections by the RBI have averaged 1172 mln INR over the last 50 days (see chart), and even so the 3 month interbank rate has ticked up to 8.91%. Typically Indian liquidity tightens considerably during Q1 as companies start to hoard cash on their balance sheets ahead of the March 31st fiscal year end, and this does increase the risk of a liquidity squeeze during the coming weeks, especially should foreign investors take their foot off the gas in the face of a stalling equity market.

The MBA Purchase Mortgage Index has finally broken out this week with a reading of 214.9 being recorded, the highest reading since May 2010 when expiring tax credits were boosting US home sales data across the board. This strikes us as an important milestone, since it suggests that US home purchases are not only benefiting from the influx of financial buyers (who typically are paying all cash), but that more traditional "home occupiers" are also now starting to return to the market. This has clear positive implications for overall activity levels in both the new (which remains dominated by home occupiers) and existing home markets.

The rise in purchase mortgage activity also suggests that outstanding mortgage credit may also be about to start to rise, having shrunk each quarter from June 2008 (see chart). This would obviously be of benefit to mortgage issuers (who continue to enjoy a very powerful refinance cycle that has been in place since last May) but perhaps less so for MBS holders, who have benefited from the shrinking pool of issued MBS in recent years.

Bloomberg Asia TV interview from January 22 2013. Interview focuses on US earnings, US financial sector and Europe. Weblink below.

http://www.bloomberg.com/video/shaoul-financials-poised-to-break-out-of-range-KpAIk~WxRJGhxChMWVQ~VA.html

Brazil's Current Account (CA) has deteriorated sharply in 2012 and December's data showed a record deficit of -$8.41 bln, far wider than the consensus estimate of -$6.30 bln. Current Account data is volatile, and December is seasonally a weak month, but even so there has been a clear trend towards wider CA deficits in recent months and the trailing 12 month ma recorded a new record of -$4.52 bln in December in nominal terms. As a percentage of GDP, the cumulative CA deficit for 2012 was -2.4%, which is the largest deficit seen since September 2002 at the start of the 10 year old expansion cycle.

Thus far Brazil has been able to fund its CA deficit via generous Foreign Direct Investment (FDI), and although this has been trimmed slightly in recent months this remained buoyant at $5.36 bln in December. Over 2012 as a whole, FDI totaled $65.3 bln, which was $11.0 bln larger than the cumulative CA. However, in December the CA deficit was over $3 bln larger than FDI, making it the greatest net negative month for funding since June 2010.

The picture that emerges from these trends is that while FDI threatened to cause a liquidity boom in Brazil two or three years ago (together with massive currency appreciation) it is now a vital source of domestic liquidity. Should FDI start to falter prior to the widening CA being addressed domestic liquidity would experience an abrupt tightening with clear negative implications for local asset values.

Interview concentrates on European markets, US and European financial sectors and interest rate risk.

http://watch.bnn.ca/business-day/january-2013/business-day-am-january-22-2013/#clip848831

US Existing Home Sales for December were estimated at 4.94mm homes, narrowly missing consensus of 5.10mm, while November's data was nudged lower to 4.99mm from 5.04mm. Despite the narrow miss, this keeps the data in its strongly appreciating trend, with sales in December 12.8% above their level of a year ago. Furthermore there are clear indications that it is supply that is now holding back demand in a number of markets. Total inventory plunged by 170K (8.54%) to 1.82mm homes, the lowest number of homes on the market since January 2001, indicating that demand outstripped supply in a number of key markets.

Clearly there are seasonal factors at work here, with many homeowners unwilling to list new homes in the winter months, while financial buyers remain keen to purchase homes no matter the season. Nevertheless the trend seems clearly to be towards much tighter markets, and we are starting to hear anecdotes from hotter markets that behavior is starting to mimic boom rather than bust conditions. Indeed in markets such as Manhattan and Brooklyn, bidding wars have become commonplace within a day or two of a property being placed on the market.

On a national basis this is clearly not the case (although competition for foreclosed homes from financial buyers has certainly intensified greatly), and what was a national housing crash is turning into a regional housing recovery, with substantial differences being felt according to prevailing employment and inventory. As would be expected in the hottest markets, home prices are starting to show clear signs of being adjusted higher, although the lagging nature of the appraisal process means that for buyers relying on mortgages this may make financing harder to come by (affordability is much less of an issue at current mortgage rates). Even allowing for some constraint in financing over the coming months we would expect a steady migration of individual markets from distressed, to stable, recovering and finally to booming.

None of this warrants the current monetary conditions, not to mention keeping them in place for a further two years or more. But despite the fact it was an excess in housing that was the primary cause of the recent crisis, the FOMC remains fixated on its uni-mandate of lowering the official unemployment rate and has shown little concern about financial assets in recent months.

There continues to be a very wide divergence between sentiment amongst individuals polled for the monthly ZEW Financial Market Survey and the performance of the local DAX index. The latter has pushed its way up to a 6 year high in recent weeks and would seem to have a decent chance of reaching a new record level in 2013, while the Current Situation reading of the ZEW survey remains close to neutral at 7.1. This dour reading is slightly higher than expectations of 6.2 and is also the second consecutive month that the survey has inched higher, at least suggesting that an important inflection point may have been reached.

This notion is supported by a very large bounce in the Expectations survey, which rose to 31.5 from 6.5, vastly outstripping consensus of 12.0 and registering its highest reading since May 2010 right at the start of the Eurocrisis. This suggests that German sentiment is starting to catch up with the reality that the local economy has come out of the Eurocrisis intact, with substantially easier monetary conditions in the form of both lower interest rates and overall liquidity.

Many of the same points that we made regarding Switzerland's monetary conditions earlier this morning would seem to apply to Germany, although at least the Bundesbank can say that it was dragged screaming and kicking to the ECB's altar.

The SNB would appear to have been successful in its multi-month effort at defending the CHF from appreciating beyond the 1.20 level against the EUR. Indeed in recent days the cross rate moved as high as 1.256 before settling down around the 1.24 level at the end of last week.

However, this substantial success in currency management has come at a cost of allowing local liquidity to balloon substantially higher. Although the majority of the SNB's interventions remained penned in on its balance sheet, the overall monetary aggregates suggest that a substantial amount of additional liquidity has found its way into the wider economy. December's monetary report shows M1, M2 and M3 grew by 11.75%, 10.64% and 9.85% over the course of 2012.

Although other Western nations have seen rapid growth of monetary aggregates, this has followed a period of substantial asset price destruction which somewhat ameliorates the effect of creating new liquidity (at least until the point that this liquidity starts to pull asset prices rapidly higher as may be happening in the US at present). Switzerland is unique in terms of only producing this new wave of liquidity in order to manage a currency, which in our opinion makes it a much more dangerous policy to have conducted on the scale of recent months.

Unsurprisingly local asset prices are showing the effects of the SNB's largesse. Real estate is approaching bubble territory in several municipalities and the local equity market (SMI index) has powered its way to a new 5 year high. Strangely enough the greatest excess has taken place in the local bond market, with negative yields out as far as 4 years in sovereign debt and negligible yields thereafter. With the Eurocrisis now arguably past us it will be interesting to see how long it takes the SNB to address the clear effects of excess liquidity in the Swiss economy, but our sense is that as is the case elsewhere, the central bank is far more concerned about avoiding a return to crisis conditions than to address the next problem which is rapidly building on the horizon.

Chinese economic data was widely expected to show a modest uptick in performance in December and this was duly supplied by last night's release. Total GDP was estimated to be growing by 7.9%, just above expectations of 7.8%, which has led to a general sigh of relief that the worst may be over.

Setting aside our long held reservations about the quality of data production in China, we would contend that a small bounce up from 7.4% growth last quarter hardly represents a categorical change in direction for the economy. Furthermore it represents scant reward for the massive issuance of credit that has taken place in recent months and the pace of credit growth continues to dwarf that of economic data, suggesting a growing reliance of activity on credit issuance. This to us is the main source of misunderstanding regarding China, for growth fueled by domestic credit growth is very different from growth funded by the recycling of FX holdings generated by export activity, which underpinned the boom of 2002-8.

China also published its Industrial Production, Retail and Fixed Asset Investment, all of which showed the same type of modest improvement. All three categories continue to grow much faster than GDP, again suggesting that little re-balancing if any is taking place. At this point the views of China have split between those looking for stable recovery and those wary of the risk of some significant disruptions and this morning's data will not settle matters either way (although it will mollify those in the former camp). We await the earnings of multinational companies to see if this improvement in data is reflected in actual economic activity as measured by corporations rather than governments.

We are still in the "silly season" for Claims data, when holiday adjustments make it even harder than usual for the survey to reflect reality, but even so this week's 335K report should be counted as an upside surprise. This is the best data released since January 18th, 2008 (another holiday affected report) and suggests that even if the improvement is overstated, some significant progress has been made in recent weeks.

The more reliable 4 week ma of the data has now fallen to 359.3K and remains close to the key 350K level. Given that in recent years the data has tended to improve from January to late March (partly due to seasonal adjustments), there would seem to be a reasonable chance that the key 350K level will be breached this quarter by the 4 week ma. The fact that this is all taking place with the FOMC still mulling the need for additional emergency intervention is an indication of how "off base" this body has become, with its unhelpful bias towards academic input meaning it can no longer distinguish the wood from the trees. Our concern remains that the bond market will prove to be a much more worldly and pragmatic reader of the overall picture than the FOMC.

A good article that highlights the shift in Chinese funding from longer term loans to short term Trust products. We have spent several weeks pointing out that China's reliance on credit products has started to balloon alarmingly in recent months (corporate bond issuance being the other egregious example) and this issue is starting to get some attention in the wider coverage.

However, the consensus view remains that the PBOC has applied "monetary stimulus" to the local economy, which would be very different in terms of risk than the sudden boom in credit issuance that has in fact taken place. At best China is misunderstood, at worst it is downright dangerous.

Ironically this article highlights the point that we were trying to make in yesterday's inaugural "Media Trends" research note. We do not doubt that news stories mentioning the "Debt Ceiling" will increase markedly in the coming weeks, but it is unclear to us what effect this will have on equity markets.

The economic conditions of early 2013 are somewhat different from mid 2011, as is the overall state of sovereign credit markets (prevailing yields in most countries are far lower, while the overhang of default risk in Eurozone countries has dissipated almost entirely). Furthermore those investors who were inclined to use Washington as an excuse to cut holdings already took action during the grubby Fiscal Cliff episode, which has only just been completed, meaning that they are largely out of the market already. We continue to believe that it is earnings which will determine the movements of the SPX index over the coming weeks far more than the course of the debate in Washington.

+------------------------------------------------------------------------------+

Debt-Ceiling Debate Returns to Haunt Stocks: Chart of the Day
2013-01-17 00:00:01.0 GMT


By Andrew Rummer and Corinne Gretler
Jan. 17 (Bloomberg) -- Eighteen months after the last round of U.S. debt-ceiling talks pushed stocks lower, the impending confrontation between congressional Republicans and the White House over federal borrowing is returning to haunt markets.
As the CHART OF THE DAY shows, the number of news stories including the phrase “debt ceiling” has surged since Congress passed a deal to avoid more than $600 billion of tax increases and spending reductions on Jan. 1. The last time there was such attention on the term, in mid-2011, the Standard & Poor’s 500 Index plunged 16 percent.
“The more the politicians will be seen fighting, the more volatile the stock market will get,” said Alessandro Fezzi, senior market analyst at LGT Bank Schweiz AG in Zurich. The debt ceiling is “seen as one of the biggest risks to the world economy. I think it’s a good reminder of the fundamental problems we still face. That doesn’t mean politicians won’t find a compromise in the last minute, as they so often do.”
Lawmakers may need to approve an increase in the $16.4 trillion debt ceiling as early as mid-February, with Republicans planning use the vote to force President Barack Obama to accept cuts in entitlement programs such as Medicare. While Congress has raised or revised the limit 79 times since 1960, negotiations over the threshold in 2011 led S&P to strip the U.S. of its top AAA credit rating and pushed the nation’s stocks within 1 percentage point of a bear market.

--Editor: Sheldon Reback

To contact the reporters on this story:
Andrew Rummer in London at +44-20-7073-3722 or [email protected]; Corinne Gretler in Zurich at +41-44-224-4100 or [email protected]

To contact the editor responsible for this story:
Chris Nagi at +1-212-617-2179 or
[email protected]

The NAHB Homebuilder Sentiment Index was unchanged at 47 in January and while this technically is a "miss" compared to expectations of a nudge up to 48, we have no problem with the data taking a breather after the massive boost to sentiment that has taken place in recent months. As can be seen on the chart, there was very little movement in the sub-indexes with Traffic, Future and Present sales all remaining at healthy but not exuberant levels.

In any case we are fast approaching the key Spring selling season (which traditionally kicks off after Superbowl Sunday), in which sentiment will have to be turned into sales in order for the rally in homebuilders and building products to have proved to be justified. We are confident that this will prove to be the case based on our own research into a number of key markets and the sales data published by public homebuilders in recent weeks.

The importance of a genuine construction cycle cannot be overstated, not only for companies directly associated with the industry but also for the wider economy, particularly with regards to employment. There is no sign that the FOMC has considered a substantial boost to the latter coming from construction activity in 2013 when setting the 6.5% target for unemployment.

Despite the general perception that it is suffering a deep recession, Italy's export data continued to set new highs in November. Total Exports were €33.59 bln, a new record for November in the NSA data and a rise of 3.55% from November 2011. The seasonally adjusted data (see chart) was €32.88 bln, a rise of 0.38% from October and 4% from November 2012. Note that November's data was no fluke since the trailing 12 month ma of both data series reached a new record this month.

Import activity has declined (as would be expected) with November showing a drop of -7.2% from 12 months ago. Note this compares with a decline rate of -27% in mid 2009, emphasizing how much milder the current slowdown is compared to the 2008/9 collapse in activity. Current import activity is the equivalent of early 2007, which really suggests that the slowdown in trade is at this point quite modest in impact.

As would be expected from the above, Italy's Trade Balance has improved significantly in recent months, reaching a surplus of €2.23 bln in November. The 12 month ma of the Balance has reached €855 mln, its highest level since October 2002. Overall an encouraging set of data from a portion of the Italian economy that is far closer related to corporate activity than the "catch all" GDP data, which is skewed by a sharp slowdown in the public sector.

Weblink for non-terminal users:

http://www.bloomberg.com/video/shaoul-doubts-debt-ceiling-talks-to-derail-stocks-OL2wTI72QIWFYSkFaGR_kg.html

Interview concentrates on debt ceiling, resilience of US equity market and the obsessive focus on Washington.

In recent days the EUR/CHF cross has moved decisively above the key 1.20 level, which has been doggedly defended by the SNB since late 2011. This morning saw the cross reach a high of 1.237 before pulling back slightly to reach 1.236 at the time of writing. The speed of the change in tone to this market and the powerful burst out of the multi-month range suggest that this move has caught many investors off guard. At the very least an injection of currency volatility should dampen the enthusiasm to hold Swiss sovereign credit at below zero yields.

Of course this move still needs to be taken in a longer term perspective and the cross has fallen from a pre-crisis level of around 1.50 CHF and an all time high of 1.68, but the move above the recent range suggests that the capital flight of the Euro-crisis has been replaced by a sudden willingness to hold Euro-denominated assets. Furthermore the strong rallies seen in peripheral sovereign and equity markets show that these flows have been very different from the "Germany first" investments made following the launch of the LTRO (the correct policy to follow at that time).

Meanwhile in addition to the radical shift in investor sentiment there is at least one good fundamental reason for the Euro's recovery, namely a marked improvement in the Eurozone trade balance which reached €13.7 bln in November (see chart). The 12 month ma of this measure is €6.95 bln, the highest reading since early 2003 and it should be noted that this improvement has been brought about by a surge in export activity as well as an understandable slippage in imports.

We note that the Bloomberg Financial Conditions index (BFCIUS), which measures a basket of equity and credit measures to gauge the state of the US financial system closed above 1 (indicating that conditions are 1 s.d. above normal) for the first time since late February 2007 on Monday night. February 2007 marked the beginning of the sub-prime crisis as the first lenders were forced into bankruptcy and the SPX index suffered its first -2% single day decline in 4 years on February 27th, signaling the beginning of the turbulence that was to accelerate for the next two years.

This strikes us as a significant milestone that completes the 4 year recovery process from the depths of the crisis when this measure reached a remarkable negative reading of -12.6 s.d. in October 2008. What is perhaps remarkable is not that conditions have recovered to this degree, but that it has done so with the FRB maintaining a full crisis position with regards to policy. We understand that "Financial Conditions" are a nebulous and subjective grouping of measures that lack the political punch of an unemployment rate, but this index has done a fairly good job of tracking the excesses of exuberance and despair over the last 15 years and its message should not be ignored.

By reaching 1 it is suggesting that conditions risk moving from healthy confidence to something a little more reckless (a state that has been reached in much of fixed income), and while the FRB may be correct in asserting that inflation is not a risk at the current time the misallocation of investor capital has been a massive cause of woe in recent decades. We are particularly concerned that the last round of quantitative easing has lulled investors into a sense that the FOMC has matters under control. As the attached chart makes clear the 2012 easings were the first that were made when the index was already in comfortably positive territory, arguably signaling that a modest tightening was probably a more appropriate policy response. Instead the FOMC has been lured by the promise of "unorthodox" monetary policy to reduce unemployment with little adverse cost. We increasingly doubt that matters will prove to be this simple, and see the risks of yet another asset price spiral as having increased measurably (arguably it has already occurred in many fixed income markets) as a consequence of the FOMC's position.

One of the nice things about Chinese CPI is that (unlike so much of China's official data) it actually fluctuates from month to month. This does not necessarily mean that it is an accurate measure but at least it gives an observer a sense of trend for the underlying inflationary trends.

It would appear China's inflationary impulses are once more heading higher, with December's CPI reaching 2.5% up from 2.0% in November and higher than consensus estimates of 2.3%. This is the highest rate seen since May 2012 and although in itself it is not a problematic reading, if it proves to be a turning point in the inflationary cycle it will pose problems for the PBOC, which is currently a passive observer of a credit boom which has reached historic proportions.

There are some tentative signs from Japan's bank lending data that the change in liquidity provision policy in late 2012 is having some effect. Total bank lending (ex trusts) has grown by 1.4% over the last year, which is the quickest pace seen since October 2009. Loans Outstanding are currently ¥401.3 trln, which is the largest amount since January 2010. Clearly Japan's lending industry remains in fragile shape, with loans outstanding well below their levels of 15 years ago (when they exceeded ¥520 trln), but positive credit growth now seems to be taking place with the hope that this process will accelerate going forwards.

Anyone wondering the impetus for a drastic change in Japanese monetary and currency policy should look at the chart of Japan's Trade Balance, which has deteriorated from a perma-surplus to a large deficit in a surprisingly short period of time. November's deficit of ¥847.5 bln was a record for this calendar month (the data is not seasonally adjusted) and compares to a -¥588 bln in November 2011 and a surplus of ¥262 bln in 2010. One piece of good news for the Japanese authorities is that it is generally easier to weaken a currency in the face of a substantial trade deficit rather than a surplus for obvious reasons.

November's data was also notable for the re-emergence of the US as China's main export market. Japan's exports to the US were ¥933 bln, compared to exports to China of ¥858 bln (see chart). US exports have also grown by 5.3% YoY while exports to China continue to shrink rapidly at -14.5% (the political spat over island territories has been a factor in this shrinkage, as has slower Chinese economic growth). The sharp move in the USD/JPY cross can be expected to further boost exports to the US going forwards.

India's economy continues to stagnate domestically, while the trade balance with the outside world continues to push on towards a record deficit for the fiscal year 2012/13.

Regarding the latter December's Trade Balance was -$17.6 bln, a rise of 20.3% from December 2012. Over the past 12 months the deficit has averaged -$16.5 bln a month, compared to a pace of -$13.5 bln a year ago. As can be seen on the attached chart, exports have been shrinking over this period (they have dropped -5.5% in USD terms since the start of the fiscal year in April), while imports have been static at recent record levels. Although oil imports remain the largest single item, the RBI has consistently mentioned gold imports as a major source of currency drain for the country. The persistently high trade deficit does therefore raise the threat of official intervention to curb imports of physical gold at some point in the future. We note that the INR remains vulnerable at its current rate of 54.67, but the rate would have to break above 56 to signal that a new currency sell off had begun in earnest.

Falling exports are rarely beneficial for local industrial activity, and November's Industrial Production data suggests that this portion of the economy continues to stagnate. After a sharp bounce in October the IP index fell back to 167.3 in November, a drop of -0.1% YoY (compared to consensus for a modest rise of 0.1%). The trailing 12 month ma (a more reliable indicator) was flat at 171.4, and is up under 1% from its level of a year ago. We continue to believe that the Indian economy is under far more duress than foreign investors realize, but await confirmation from this earnings season that this economic weakness has translated into poor corporate performance.

China's December monetary data showed a continuation of the multi-month trend of replacing liquidity with credit as the prime driver of domestic economic activity.

Moreover, it is now non-bank credit which is starting to dominate; total CNY loans for December were "only" 454 bln CNY, well below consensus expectations of 550 bln. Even so total CNY loans outstanding rose 8,195 bln CNY (14.96%) over 2012 the second largest amount on record. Readers should note that this is approximately $1.3 trln, which means that Chinese bank lending is increasing at approximately twice the nominal pace of US bank lending in the 2005-7 credit boom, in an economy that is substantially smaller. However, it is really non-bank credit which has been the major source of funds with total "Social Financing" (which includes CNY loans as a sub-category) reaching 1,630 bln in December, its highest level since June. This means that bank loans only accounted for around 27.8% of total financing, which is the lowest ratio since December 2007 (see chart).

It also means that 2012 total financing increased by an average of 1,315 per month, or 15,780 bln CNY for the year, comfortably a new record. This would be around $2.6 trln, somewhat faster than peak US credit creation in 2005 (which we roughly estimate to have been $2.5 trln).

This is roughly reflected in China's monetary data where there continues to be a dichotomy between narrow money (M0 and M1), which is linked closely to the PBOC's liquidity actions (see earlier note on FX reserves) and broader measures such as M2, which is also influenced by credit creation. For 2012 as a whole M0 grew by 7.9%, the lowest since 2001, M1 grew by 6.5%, the lowest on record, while M2 grew at 14.4%. Although this is the lowest pace since 2000, M2 is still growing at a faster pace than the overall economy, but it is clearly "non-M1 M2" which is now doing the heavy lifting within the Chinese economy.

China's trade data finished 2012 with a burst higher with both imports and exports running ahead of consensus. Imports were $167 bln, a rise of 6% compared to December 2012. This means that for the whole of 2012 imports grew by 4.3% from 2011's pace of activity, which is well below both GDP and many of the single industry metrics. Export data was somewhat stronger, rising to a new all time high of $199.20, a 14.1% increase over December 2011. For the whole of 2012 exports experienced a rise of 7.9%, roughly in line with GDP, but far below the pace enjoyed for most of the last decade.

On the surface this data would support the view that the global economy has stepped back from the brink, allowing China's export industries to participate in the rebound of activity. To some extent we would agree with this interpretation, but as ever with Chinese data there is room for some skepticism. One of our concerns remains the very large role that exports to Hong Kong (which then are re-exported elsewhere) have played in the export rebound in recent months, and December was no different. Once more this was the biggest category of exports at $37.66 bln, a 34.4% YoY rise.

Our other concern is a mismatch between China's reported trade surplus and FX reserves. China's trade balance reached $31.62 bln in December and has averaged $19.28 bln over 2012 for a total of $231 bln. China's reported FX reserves grew by $128.9 bln over 2012, the smallest nominal growth since 2003. In percentage terms FX reserves have grown by 4%, the smallest increase since 1997.

We have no insight into the reason for this discrepancy (or which of the data sets is more accurate). However, as our note on China's monetary data (which was also released last night) will make clear, China has made a substantial transition from a liquidity based monetary system where FX reserves are recycled through the banking system to one largely fueled by rampant non-bank credit growth.

It is starting to appear that the long US refinance boom may be drawing to a close as the pool of qualifying homeowners has diminished following 8 months of surging activity.

We have traditionally used a 4000 reading in the weekly MBA Refinance index to define "boom" conditions and the last two weeks have seen applications fall short. We would allow for holiday based distortions (although the index is seasonally adjusted, this is an imperfect process around key holiday periods), but we would also note that the tick up in long dated bond yields may also have played a part in reducing demand.

We have therefore updated our long running chart, which shows refinance booms and the crises to which they are related (since crises reduce bond yields making refinancing more attractive). We suspect this long and important relationship may be drawing to a close, since we doubt that the next bump in the road will generate a 30 year mortgage rate substantially lower than we saw in late 2012 (then again we said the same thing in 2010).

In any event, if refinancing activity does now start to diminish this would result in somewhat less "technical" demand for Treasuries from MBS holders seeking to hedge the duration shift caused by early repayment of mortgage bonds. We doubt that this is much of a factor yet, but should refinance demand take another leg down, then we may witness the sort of sudden spike upwards in yields that greeted the end of prior booms over the last 15 years (see chart).

India's car sales appear to have stagnated in recent months with the first 9 months of the 2012/13 fiscal year (which ends on March 31st) seeing a drop of -0.11% from 2011/12. December's sales of 141K were down -11.45% from December 2011 but the data is volatile on a monthly basis making single month comparisons unwise. However, we feel comfortable in asserting that Indian car sales are now at best in a zero growth environment, and given the very strong sales seen in the January - March 2012 period, are likely to register a substantial YoY decline once the books are closed on the 2012/13 fiscal year.

Meanwhile Indian vehicle exports are similarly stagnant; December's exports of 240K vehicles was -1.9% below the pace of December 2011 and means the first 9 months of 2012/13 are -2.9% below that of 2011/12. Although this is a trivial reduction, it should be remembered that the sharp drop in the INR over the last 18 months should have provided a substantial boost to exports. This lack of growth is also a substantial change from the powerful growth in exports seen for most of the last decade.

None of this seems to matter to foreign investors, who continue to pour new funds into Indian equities. 2012 saw the second largest flows for a calendar year at $24.5 bln. The first week of 2012 has seen a further $1,240 invested, which is the fastest start to a year on record (see chart). Quite simply India's economic and corporate data has done nothing to warrant such enthusiasm and although equity prices will remain buoyant for as long as the spigot pouring in funds, in the end substantial disappointment for investors seems likely to occur.

This article makes some of the points that we argued in last week's note on Chinese monetary policy. The shift from liquidity to credit stimulus, and further moves away from bank lending to less regulated forms of credit have not generally been well understood. It is therefore interesting to see one of the larger houses start to focus on this issue.

Given the size of the sums involved (we estimate total Social Funding of $2.5 trln annually, which matches that of the peak of the great credit boom in the US in 2005) it seems likely that rather more attention will be paid going forwards, particularly if any hint of delinquency can be detected. We have attached a copy of last week's chart as a reference.

+------------------------------------------------------------------------------+

China Loan Share at Record Low Shows Financing Risks: Economy
2013-01-09 07:14:37.788 GMT


By Bloomberg News
Jan. 9 (Bloomberg) -- China’s bank loans as a share of
funding in the economy may have fallen to a record low,
highlighting the growth of alternative financing channels that
have prompted warnings of rising credit risks.
New yuan loans probably dropped 14 percent last month from
a year earlier, according to the median projection in a
Bloomberg News survey of 37 analysts ahead of data due by Jan.
15. That would give bank lending a 55 percent share of aggregate
financing for 2012, based on UBS AG estimates, the least in
figures dating to 2002.
The decline underscores the waning ability of official loan
data to capture the scale of debt in the world’s second-largest
economy as borrowers and investors turn to less-regulated,
higher-return shadow-banking products. The People’s Bank of
China is putting greater emphasis on aggregate financing and the
International Monetary Fund says the growth of nonbank credit
poses “new challenges to financial stability.”
“China’s economic performance in 2013 will be
significantly affected by how seriously Chinese regulators are
going to treat non-bank financing,” said Shi Lei, a Beijing-
based analyst with broker Founder Securities Co., who has
provided research advice to China’s securities regulator. While
a hands-off approach will help the economy, a crackdown “would
be really bad for growth.”
The PBOC lending figures are among December data in the
coming days that will show whether an economic rebound that
began in September picked up or slowed last month after a seven-
quarter growth slowdown. Trade figures due tomorrow may show
exports rose at a faster pace and a Jan. 11 report may indicate
inflation accelerated.

Growth Pickup

The government will release fourth-quarter gross domestic
product as well as December industrial production, retail sales
and fixed-asset investment on Jan. 18. Economic growth probably
accelerated to 7.8 percent in the quarter from a year earlier,
up from a three-year low in the previous period, according to a
Bloomberg News survey last month.
China’s benchmark stock gauge, the Shanghai Composite Index,
was little changed today. It has gained 16 percent since an
almost four-year low on Dec. 3 on signs the economy is picking
up.
The PBOC in April 2011 started providing data on aggregate
financing, which includes bank and non-bank lending, on a trial
basis as part of the release on loan and money-supply statistics.
In September 2012, the central bank began issuing a
separate monthly press release on the broader indicator,
emphasizing it by waiting at least five hours before putting out
the monetary figures. The PBOC also gave historical data for the
previous decade, illustrating how bank loans have declined from
their 2002 share of 91.9 percent.

Closer Correlation

Sheng Songcheng, head of the PBOC’s statistics department,
said in 2011 that aggregate financing is more closely correlated
with GDP and inflation than new yuan loans. The slice of funding
may shrink further amid China’s “rapid development of financial
innovation,” the PBOC said in September.
Aggregate financing, also called total social financing,
includes banks’ yuan loans and six other categories: foreign-
currency loans, entrusted loans, trust loans, bankers’
acceptance bills, corporate bonds and non-financial stock sales.
“As trust loans, bonds and other non-bank financing grow,
the central bank has a full reason to promote the new
indicator,” said Joy Yang, chief Greater China economist at
Mirae Asset Securities (HK) Ltd. in Hong Kong, who previously
worked at the IMF.

Deposit Pools

Trusts typically offer better rates of return than banks,
pooling deposits from businesses and households to invest in
real estate, stocks, bonds, commodities, or other assets.
Lending by so-called trust companies surged five times to
1.04 trillion yuan ($167 billion) in the first 11 months of 2012
compared with the whole of 2011. A “large part” of the
sector’s lending is to higher-risk entities including local-
government investment vehicles and property developers, and
investors may underestimate risks, the IMF said in its Global
Financial Stability Report in October.
Aggregate financing was probably 15 trillion yuan last year,
according to UBS. The median estimate of seven analysts surveyed
by Bloomberg was for 1.2 trillion yuan in December, compared
with 1.27 trillion yuan a year earlier.
The PBOC may also say that China’s foreign-exchange
reserves, the world’s largest, rose to a record $3.32 trillion
at the end of December from $3.29 trillion three months earlier,
based on the median estimate of seven economists. M2 money
supply probably rose 14 percent in December from a year earlier,
up from a 13.9 percent gain in November.

Australia Retail

Elsewhere in the Asia-Pacific region today, an Australian
government report showed November retail sales unexpectedly fell
0.1 percent from October, the first drop in four months. The
Bank of Thailand will keep the benchmark interest rate unchanged
at a policy meeting today, all 22 economists surveyed by
Bloomberg forecast.
In Europe’s day ahead, separate reports may show the U.K.
trade deficit narrowed in November from a month earlier and
German industrial production probably gained for the first time
since July, according to the economist surveys.
In North America, Canada may say housing starts were little
changed in December, while the U.S.’s Mortgage Bankers
Association will report loan applications for the week ended Jan.
4, after the index fell for the previous three periods.
Tomorrow’s China customs administration report may show
exports rose 5 percent last month from a year earlier, up from
2.9 percent in November, while imports gained 3.5 percent after
being unchanged the prior month, based on analyst estimates.
Overseas shipments gained 13.4 percent in December 2011.
“The major drag in the near term lies in the external
sector,” Zhu Haibin, chief China economist at JPMorgan Chase &
Co. in Hong Kong, wrote in a Jan. 7 note.
Consumer prices may have increased 2.3 percent in December,
the fastest rate since May, in statistics bureau data due Jan.
11. McDonald’s Corp., the world’s largest restaurant chain,
raised some menu prices in China because of higher labor and
input costs, the company said Jan. 7.

--Zhou Xin, Kevin Hamlin. With assistance from Cynthia Li in
Hong Kong, Ailing Tan in Singapore, Sunil Jagtiani in New Delhi,
James Mayger and Andrew Joyce in Tokyo and Brendan Murray in
Sydney. Editors: Scott Lanman, Stephanie Phang

To contact Bloomberg News staff for this story:
Zhou Xin in Beijing at +86-10-6649-7731 or
[email protected];
Kevin Hamlin in Beijing at +86-10-6649-7573 or
[email protected].

To contact the editor responsible for this story:
Paul Panckhurst at +852-2977-6603 or
[email protected]

We have commented recently on the divergence of consumer confidence measures in the Eurozone from that of local equity markets. It is therefore unsurprising that the overall European Commission measure of confidence should show the same divergence, but it is still worth revisiting this issue since it has significant positive ramifications for European equity markets.

In general consumer confidence measures are strongly correlated with equity market performance, and therefore have little predictive use for investors (they merely remind you that the local market has been weak or strong). The times that confidence measures can be useful are when they reach the extremes of bullish or bearishness (when they are contrary indicators) and when they diverge markedly from local equity market performance.

At market bottoms the vast majority of sentiment is negative, and consumers and investors are reluctant to change their mind. However, if these investors have already liquidated their holdings their opinion is no longer of relevance to the market, while the determination of the few remaining bulls can be enough to effect a substantial turn around.

As the attached chart shows, we are currently witnessing a very substantial divergence in Europe between confidence and market performance (we are using the Bloomberg Europe 500 index as a broad measure of the latter). The index has rallied by 5.57% over the last 3 months while European Consumer Confidence has slipped from -25.9 in September to -26.5 in December (the latter being a small improvement on November's -26.9 reading). Back in 2009 confidence and market performance were much more closely correlated, as was the case with the steep declines seen in 2007/8 and 2011. We take substantial comfort from the lag of confidence this time around, but would expect it to start to improve markedly should European equity markets continue to make progress in the early months of 2013.

We have included a chart breaking down confidence by individual countries (we have truncated the universe to markets we find interesting) over the last 20 years for reference purposes. Readers will not be surprised to see that Greece has comfortably the worst readings at -72 (not that this stopped the local equity market from rallying last quarter) and that Southern Europe in general has substantially negative confidence. Even Germany which is stable economically and enjoyed a 29% rally in the DAX in 2012 (the best performance since 2003), has a -10.4 reading at the current time.

In recent weeks the EUR has recovered some of its pre-crisis strength, moving back above the $1.30 level towards the end of 2012. Against the CHF far less progress was made, but the EUR did manage to reach a high of 1.216 in the EUR/CHF cross, before the rate settled back lower at around 1.208. This at least keeps the cross comfortably above the intervention rate of 1.20 and it is now several weeks since the SNB has been forced to take action to halt the CHF's appreciation.

This is reflected in the SNB reserves, which were almost unchanged at 427.2 bln CHF and actually fell by 2.3 bln CHF (-0.54%) over the 4th quarter. This hardly dents the massive build up of reserves since the start of the Eurocrisis in Q2 2010. Reserves were 125 bln CHF at the end of March 2010, 300 bln less than their level at the end of 2012.

Although we doubt that further intervention will be required, the mopping up of this excess liquidity remains a massive task for the SNB. One source of help would be a reduction in demand for "safe haven" deposits. In Switzerland's case, demand for CHF holdings has pushed sovereign yields into negative territory out as far as 4 years, while cash deposits in a number of banks are now being charged interest. This is hardly a normal situation, but it remains to be seen if investors' confidence in the stability of other large currency blocks will reach the point that capital starts to be redeployed out of Swiss holdings. We certainly think this is a possibility going forwards, particularly should yields in the US, Europe and Japan continue to track higher in the manner of recent weeks.

Most readers will be aware of the sharp rally in Japan's local equity market and concurrent decline in the JPY that has taken place in recent weeks in anticipation of a more interventionist monetary policy by the BOJ following the election of Premier Abe. December's monetary data suggests that even without this political shift the BOJ has undertaken significant quantitative easing in recent months, with December showing particularly powerful growth of over 6% in the raw data and 2.78% on a seasonally adjusted basis (the monetary base typically expands rapidly ahead of the New Year holiday in Japan, hence the large seasonal adjustment).

This takes the YoY growth rate up to 12% (using the seasonally adjusted data), which barring the brief response to the 2011 earthquake is the fastest growth since the experiment with quantitative easing a decade ago. Critics will point out that the BoJ has restricted itself to short term "cash substitutes" rather than the much longer term and credit sensitive instruments utilized by the FRB and ECB, but given the extremes that both the local equity market and currency found themselves at the start of the 4th quarter, perhaps this was all that was required to start to push the markets in the opposite direction.

Of course none of this will lead to sustainable economic growth without credit creation. November's credit outstanding data was also released last night. This showed business credit growing at a tiny 0.4% level, with credit outstanding down sharply from its level of a decade ago. Consumer credit on the other hand has grown consistently in recent quarters, at a rate a little faster than 2% and is at a new all time high in November's data. This is not the worst basis for monetary intervention to take effect, and it will be very interesting to track this data going forwards.

The ISM Non-Manufacturing Survey continued the robust start to the December data cycle, with the index rising to 56.1, well above consensus of 54.10 and the highest reading since February 2012. This is a relatively volatile report on a monthly basis but the trailing 12 month ma is 54.7, which is a solidly positive level. Unlike the Manufacturing survey this data has not come close to negative territory in recent months, which is unsurprising given the influence of the residential housing market and retail sales on the US service sector.

We do not spend a great deal of time parsing the details of this secondary data but it is worth pointing out that New Orders in particular were strong at 59.3, and this is echoed by the 12 month ma which rose to 56.6. Although service industries do not have the same relationship to inventory and backlogs that the manufacturing industry does (although the ISM does measure these sub-sectors in this survey), New Orders would seem to be an important metric for future business activity, and we take encouragement from its robust standing.

We have always argued (and more importantly observed) that the point at which consumer activity in an economy starts to recover is not when unemployment starts dropping quickly but when it stabilizes, even if this stabilization takes place at a very high level.

This is because for the employed majority it is the fear of future unemployment which constricts spending during the period of massive lay-offs, and once this fear is removed on a personal basis, the need for frugality starts to diminish. This was certainly the case in the US during the summer of 2009 and we expect the same pattern to hold for Ireland as 2012 turns to 2013.

Ireland's Live Register of Unemployed fell by -1.4K in December to 430.9K, the 6th consecutive drop and the 9th drop over the whole of 2012, during which time the Register fell by a total of 11.6K. This still keeps the Register almost 300K higher than it was at the height of the boom, but a steady downwards trend is now in evidence in both the monthly data and trailing 12 month ma. The unemployment rate remained at 14.60%, which is a modest drop from the peak reading of 15.0%, again suggesting the worst of the employment cycle is behind us. It should also be noted that Ireland has survived very high unemployment in both the mid 1980s (when the rate peaked at 17.30% in 1985) and early 1990s (when the rate peaked at 15.70 in January 1993). This is not to minimize the pain of the current situation, but January 1993 was the start of a remarkable 8 year boom that took unemployment down to 3.70% in January 2001.

We do not expect as strong a recovery this time around, but we do expect things to get markedly better in Ireland, and at a faster rate than is generally expected.

The December 2012 employment report was essentially in line with expectations, which were themselves for a month of solid but unspectacular employment growth, while last month's data was revised somewhat higher. Total Payrolls were estimated to have risen by 155K, just above consensus of 152K and November's data was revised upwards from 146K to 161K. This means that the last two months have been in line with the trailing 12 month ma of 155K (which itself has been a very stable signal for a number of quarters).

Private Sector Payrolls were estimated to have grown by 168K, somewhat better than consensus of 152K (as a side note the fact that this is 47K lower than yesterday's ADP report suggests that the revision to ADP's methodology has not brought this measures into line with BLS data and that they remain two separate "guesstimates") and November was revised strongly from 147K to 171K. This kept the 12 month ma at 158.6K, and it should be noted this measure has barely budged for 18 months leading us to believe that overall employment gains have been fairly steady at this level for this period, no matter what the monthly fluctuations in BLS survey methodology and seasonal adjustment generates.

The Household Survey (which generates the Unemployment Rate) does not have a consensus estimate and historically has been relegated to the sidelines of what we like to call "Non-farm Nonsense". Given the FOMC's obsessions with the Unemployment Rate we expect this data to start to receive rather more attention going forwards. As regular readers will be aware it has been in a steadily rising trend for a number of quarters but is even more volatile on a monthly basis than the Establishment report that generates the headline data discussed above. December showed a modest 28K gain in employment while November's report was revised strongly higher from -122K to 51K. The 12 month ma moved slightly lower to 201K, which compares to a reading of 133K in December 2011.

Meanwhile the key Unemployment Rate was revised higher to 7.8% in November from 7.7% and kept at that level for December. This still keeps the rate on course to reach 6.5% well ahead of FOMC expectations if hiring conditions for 2013 replicate the last 18 months, while any improvement to hiring trends (which we believe would be most likely to be driven by residential construction) would bring the rate below 7% by the end of 2013. It remains our belief that in its attempt to clarify (and calcify) monetary policy by linking it to Unemployment the FOMC has sown the seeds of confusion in the treasury market instead.

See link: http://www.federalreserve.gov/monetarypolicy/fomcminutes20121212.htm

As would be expected, the radical change to US monetary policy linking it to a specific unemployment rate (with inflation a secondary target), which was announced at the last FOMC meeting was the subject of lengthy discussion at December's meeting.

We are on record as believing this to be the key policy error of recent years and were interested to see some of the reasoning behind it. As we wrote at the time, the FOMC has started to show classic signs that it has become "addicted" to alternative monetary stimulus, responding to sequentially smaller crises with additional rounds of "credit" and/or "quantitative" easing:

This morning saw one of the first significant upside surprises in Spanish employment data for several quarters, with total registrations falling by -59.1K, compared to expectations of a 62.5K rise. This data is the best December reading since the series began in 1996 (the series is not seasonally adjusted) and gives some confidence that Spain's unemployment spiral may finally have crested. It will take several further positive data points for this to become clear. As things stand, the Spanish unemployment register is at 4.848 mm, 9.6% higher than it was in December 2011, while the trailing 12 month ma has risen to a new high of 4.7mm, compared to a pre-crisis reading of around 2.0mm.

Obviously we do not expect to see Spain's employment return to this level for a very long time, but as we have seen in the US since 2009, bull markets generally start 3 to 6 months before unemployment data peaks and can then continue to power onwards even though the number of unemployed remains far above the historic average.

The December payroll data cycle has started strongly with the ADP Employment Report estimating that payrolls increased by 215K, well above consensus of 140K, indeed this number is higher than any of the 36 published estimates on Bloomberg, which ranged from 70K to 210K, making it a legitimate upside surprise. It is also the strongest report under the new methodology seen since February 2012 and brings an end to a string of fairly modest reports.

It should be remembered that the impetus to change the methodology was to bring ADP's report closer in line with the official BLS data (making it much less useful as an alternative measure in our opinion). Tomorrow will be the first chance to see whether this has been achieved since a print anywhere close to 210K for Private Sector Payroll gains would be well above consensus of 150K (although below the highest of 44 estimates at 220K). An upside surprise of this magnitude in the official data, particularly if combined with a further fall in unemployment would probably be enough to force long term treasury yields out of their trading range (see this morning's Weekly Speculator for a discussion of this).

Meanwhile the Challenger Job Cut report also supplied a good print, with total job cuts announced falling back to 32.5K. This is the second lowest reading since June 2000 (December 2010 being the lowest). Clearly this is "secondary" data, and the series is volatile month to month, but the 12 month ma has fallen back to 43.6K in recent months which is close to its all time low since the data started to be published 13 years ago.

An interesting article that makes some of the points that we addressed in a long note on Monday with interesting concrete examples. The scale of Chinese domestic debt creation is not generally recognized at the current time, but in nominal terms it appears to be of the scale seen in the US housing boom (About $2.5 trn a year) in an economy of substantially smaller scale.

A short clip from today's Bloomberg interview including our view on the Fiscal Cliff

http://www.bloomberg.com/video/shaoul-fiscal-cliff-a-dirty-deal-3QMy1xkuQ16y3_EbQWxAXw.html

The ISM Manufacturing Survey for December got the 2013 data cycle off to a solid start, with the index moving back up to 50.7, just beating expectations of a 50.5 reading. Even though the Prices Paid index was a large factor in this recovery, reaching 55.5, all non-inventory measures moved back into expansion territory above 50 and this is a very solid report in terms of breadth.

New Orders (red) were modestly positive at 50.3 as was Production (blue) at 52.6, which suggests that the manufacturing recovery remains on track. Interestingly both the Import (51.5) and Export (51.5) indexes were above 50, the first time this has been the case since May 2012. Employment (pink) recovered to 52.7, suggesting that modest employment gains continue to take place.

Regarding Inventories (olive), these remain in sharp draw-down mode at 43 (note this contrasts with official Census Bureau data) while Customer Inventories were slightly negative at 47. Further encouragement came from the Backlog data, which recovered from last month's very weak 41 reading to reach 48.5.

The realization that Washington is not populated by political lemmings (or giants alas) will inevitably dominate the headlines and all analysis of the market for the next few sessions, but it should not be forgotten that this drama has taken place at year end which in any case is always a key time for institutional allocations.

In recent weeks we have seen a general shift towards pro-equity allocations in global markets which really bypassed the US equity market due to the domestic political issues. We have been particularly struck by the massive flows directed back towards emerging markets in recent weeks and have attached a couple of charts to demonstrate this.

The first chart shows the change in the number of shares outstanding in the popular EEM ETF, which tracks the MXEF index (red). As can be seen inflows have soared towards the end of 2012 with shares outstanding reaching a record 1.106 bln, creating a market cap of $49 bln for this ETF. Over the last 13 weeks the shares outstanding increased by 209 mln, which is the fastest pace since December 2008 (when share creation was largely due to portfolio re-balancing in response to the collapse of value of the underlying instrument). Assuming that this ETF is an accurate proxy of general EM allocations this really demonstrates the renewed determination of US investors to maximize exposure to these markets, despite the fact that a strong (but in line) 2012 did not make up for the severe lag of these markets in 2011. Given these flows we would have expected a strong first few sessions for emerging markets in 2013 even without a deal in Washington, but we would also caution that strong calendar flows have a habit of running out by the second week of the quarter leaving the underlying market vulnerable to a pullback.

As a confirmation that this is part of a general trend we have included a chart of cumulative foreign equity flows into the Indian equity markets (India helpfully publishes this data on a daily basis). As can be seen 2012 saw a total of $24.6 bln of foreign inflows, the second highest level on record. Although the local SENSEX market had a strong 2012, these gains only served to reverse the steep losses of 2011, while the local currency actually lost substantial ground over this period. Indeed a USD investor would have lost 20.29% over the last 2 years in India and an EUR investor 19.27%. In general the domestic economic and corporate news coming out of India in recent months has been poor, and it would appear that the local equity market has benefited from "ABC" (Anything But China) flows that wished to still be exposed to emerging markets.

We would expect India's market to make gains for as long as these flows continue, but readers should recall that the November 2010 peak in the local market came at the end of an even more torrid period in the run up to QE2, when India's inflationary tendencies was used as an excuse to pour funds into the local equity market.