China

Thursday’s surprise interest rate cut by the PBOC prompted speculation that China’s monthly data for May would be especially weak when they were released this past weekend. Instead, they were mostly relatively strong:

(1) Trade. Exports in May rose 15.0% y/y to a record high, beating April's 4.9% gain. Similarly, May imports were up 12.7%, compared with April's 0.3%. Despite the recession in Europe, exports to the 27-nation European Union actually increased 6.0% in May, and 25.4% over the past three months almost back to last year's record high. Exports to the United States and to the "rest of the world" (excluding the US, EU, and Japan) jumped 10.9% and 10.6%, respectively, to new highs last month.

(2) Production. In May, China's industrial production rose 1.1% m/m and 9.7% y/y after a 9.3% rise in April. Electricity output rose only 3.2% last month, though it tends to be very volatile on a m/m basis. The three-month average increased 3.6% y/y, the weakest growth rate since July 2009.

(3) Retail sales. May’s passenger vehicle sales were up 22.6% y/y to 1.28 million vehicles. That beats April's 12.5% growth, which itself was an encouraging turnaround from a 1.3% decline from a year earlier. However, overall retail sales growth slowed a bit in May to 13.8% y/y from April's 14.1% pace.

(4) Fixed investment. Fixed asset investment climbed 20.1% in the January-May period from a year ago, just above forecasts for a 20% rise. Property development investment for the January-May period was up 18.5% y/y. The WSJ calculated that investment in May was up 18.2% from a year earlier versus a 9.2% rise in April. The official statistical bureau doesn't issue data for individual months.

(5) Money and Credit. Chinese banks made 793.2 billion yuan ($125 billion) worth of new loans in May. That’s up slightly from April’s 681.7 billion yuan lending pace. China's M2 rose 13.2% y/y in May. It has been hovering around 13% since the start of the year.

Given the strength of most these various indicators, why did the PBOC ease? The government is intent on boosting economic growth. China's central bank last week cut interest rates for the first time since the depths of 2008/09 global crisis while giving banks more freedom to set lending and deposit rates in a step along the path of liberalization. The central bank also reduced banks' reserve requirement ratio three times since last November to pump out additional funds that can be used to boost lending.

In recent weeks, the government provided incentives to purchase energy-efficient household appliances, targeted tax cuts, and accelerated approval for investment projects by companies and local governments. On Friday, officials called for additional spending on railway construction.

The PBOC has more room to ease since inflationary pressures are abating. China’s CPI came in at 3% y/y in May, down from 3.4% in April. China’s PPI fell 1.4% y/y in May, after a 0.7% y/y decline in April.

Today's Morning Briefing: Around the World. (1) Checking the “Checklist for Optimists.” (2) Chinese trade data are hot and spicy. (3) China’s electric power is low. (4) PBOC has room to ease as inflation subsides. (5) A world tour of austerity and insanity. (6) Greek strike could disrupt vote. (7) Spain gets a rescue package partially backed by Spain. (8) French socialists worrying about leftists. (9) A popular comedian-turned-politician in Italy. (10) Corruption is corroding India’s growth rate. (11) Californians on fast track to nowhere. (More for subscribers.)

Germany

The German manufacturing sector continues to battle headwinds. Factory orders fell 1.9% in April after an upwardly revised 3.2% gain in March (vs. the preliminary 2.2% estimate), remaining in a seven-month flat trend. Domestic orders rose for the third time in four months in April for a total gain of 3.1%. Foreign orders sank 3.6% after a 4.4% jump in March. Foreign orders from the non-euro region led April’s decline, plummeting 4.7% (after a two-month surge of 11.9%). These consumer and capital goods orders fell 11.1% and 7.3%, respectively, after soaring 11.2% and 15.2% in March. Orders from the euro area fell for the fifth time in six months (by 13.4%), with capital and consumer goods orders down 21.2% and 5.2% over the six-month period.

German production remains volatile around recent highs. Industrial output slumped 2.2% in April after a downwardly revised 2.2% (from 2.8%) gain in March. It’s within 3.7% of its cyclical high last July. Capital goods output declined for the first time this year by 3.6% in April, falling to the bottom of its recent flat trend. Consumer goods production fell for the fifth time in six months, down 4.2% over the six-month period to its lowest level since February 2010. It’s 6.8% below its cyclical high last summer.

Today's Morning Briefing: Easing Does It? (1) The Federal Open Mouth Committee. (2) Leaders and laggards in yesterday’s rally. (3) Staying sector-neutral for now. (4) Draghi is ready. (5) An August rally scenario following backing and filling in June and July. (6) Muddling along in the US economy. (7) Earnings season ahead. (8) Waiting for downward European guidance and positive surprises elsewhere. (9) European leaders won’t let crisis get in the way of their August vacations. (10) Romney rally. (11) Walker rally. (12) Yellen rally. (More for subscribers.)

A Primer: Corrections vs. Bear Markets

What’s the difference between a correction and a bear market? The conventional definition is that the former is a drop in stock prices that falls short of a 20% decline. Anything beyond that is a bear market. A correction tends to be caused by falling valuation multiples (P/Es), triggered by fears that earnings will drop. If earnings remain stable or continue to rise, contrary to expectations, then the P/E rebounds and the bull market resumes. If earnings do fall, then P/Es may continue to do so too, resulting in a bear market. So corrections are panic attacks that aren't validated by the fundamentals. We had a nasty correction two years ago and another one last year. It is happening again this year:

(1) During 2010, the S&P 500 forward P/E dropped 22% from a high of 14.7 on January 11 to a low of 11.4 during August 26. However, forward earnings rose all year. So the 16% correction in the S&P 500 from April 23 to July 2 was reversed by the end of the year, with the P/E ending at 13.1.

(2) During 2011, the P/E fell 25% from 13.6 on February 18 to 10.2 on October 3. Forward earnings rose during the first half of the year and remained mostly flat during the second half at a record high. So once again, the market recovered and closed higher by the end of the year with the P/E rebounding to 11.7.

(3) During 2012 so far this year, the P/E peaked at 13.0 on March 26. It was down 11% to 11.6 yesterday, just about matching the 2010 low, which was 11.4. The S&P 500 is down 9% from its high on April 2, which is still just a garden-variety correction. Meanwhile, forward earnings rose to a new all-time record high of $111.27 during the week of May 31. At this level, a retest of last year’s panic low P/E of 10.2 would push the S&P 500 down to 1135, which would be a 20% decline from the year’s high on April 2.

As you can see in our Earnings & Valuation: S&P 500 Blue Angels, the market’s volatility is attributable almost entirely to the volatility in the P/E. Earnings expectations tend to change more slowly and smoothly. The one exception is during recessions, when both variables take a dive. During the bear market from October 9, 2007 through March 9, 2009, the P/E plunged 32% from 15.1 to 10.2, with forward earnings diving 29%. The P/E actually bottomed at 8.9 on November 20, 2008.

Today's Morning Briefing: Corrections vs. Bear Markets. (1) P/E times E. (2) Corrections are driven by P/E. (3) Bear markets caused by earnings recessions. (4) A review of recent history. (5) Just another correction? (6) Earnings and valuations plunged during Great Recession. (7) A relatively optimistic outlook for revenues. (8) Profit margin going nowhere for a while. (9) Corporate cash flow hit by smaller depreciation expenses. (10) Wisconsin’s winner. (11) PATCO for public employee unions. (More for subscribers.)

Global Manufacturing



On the first business day of each month, manufacturing purchasing managers indexes (M-PMIs) are released for the US and several other countries. When the global economy is growing, they tend to exceed 50 and to be bullish for stocks. On Friday, we learned that the M-PMI for the US dipped from 54.8 in April to 53.5 in May. That’s not too bad, really. China's index dropped from 53.3 to 50.4. It’s still above 50, but disappointing relative to expectations. The unexpected jaw dropper was the index for the UK, which plunged from 50.2 to 45.9.

The euro area’s M-PMI sank even lower, from 45.9 to 45.1. That wasn’t unexpected, but it confirmed that the region has fallen into a recession that is worsening. The M-PMIs were well under 50 for Spain (42.0), France (44.7), Italy (44.8), and Germany (45.2). Germany’s index has dropped sharply recently from a reading just above 50 during February.

Manufacturing has been the leading source of growth during the latest global economic recovery, including in the US. The concern is that neither the US nor China can continue to grow for very long if the European recession continues to deepen. I think they can. However, there has always been a very strong correlation among the various M-PMIs over the business cycle. So it’s not surprising that the stock market’s reaction on Friday suggests that investors are skeptical and questioning whether the M-PMIs can decouple.

Today's Morning Briefing: Checklist for Optimists. (1) Cold and drizzling in Boston. (2) Looking at clouds from both sides now. (3) A torrent of disappointing M-PMIs. (4) Global Growth Barometer is also dreary. (5) A checklist of happy outcomes. (6) Unions vs. taxpayers. (7) European banking integration or bust? (8) Giving a pass to Greece and Spain. (9) Lower oil prices. (10) Higher German wages. (11) The Chinese and Brazilians are stimulating. (More for subscribers.)

Europe

Let’s consider the breakup of the euro zone. Is it inevitable? I believe that the founders of the EMU must have known that a monetary union without fiscal unification would eventually experience a major crisis. My hunch is that they assumed that it would force the Europeans to implement a fiscal union. That assumption is getting stress-tested right now. In my opinion, there is a plausible scenario in which the euro zone comes together rather than splits apart. Indeed, European leaders are starting to talk the talk. The question is whether they will walk the walk.

On Thursday, Mario Draghi, the ECB chief, said that the euro zone needed "further centralization of banking supervision." He appeared to give a general endorsement of the proposal outlined on Wednesday by the European Commission to create a "banking union" that would be based on a centralized regulator and bailout fund as well as an EU-wide deposit insurance backstop.

Yesterday, Reuters reported: “German Chancellor Angela Merkel is pressing for much more ambitious measures, including a central authority to manage euro area finances, and major new powers for the European Commission, European Parliament and European Court of Justice. She is also seeking a coordinated European approach to reforming labor markets, social security systems and tax policies, German officials say. Until states agree to these steps and the unprecedented loss of sovereignty they involve, the officials say Berlin will refuse to consider other initiatives like joint euro zone bonds or a ‘banking union’ with cross-border deposit guarantees--steps Berlin says could only come in a second wave.”

Spanish Prime Minister Mariano Rajoy proposed on Saturday that the 17 countries in the euro zone create a common fiscal authority, with each surrendering a significant amount of its national sovereignty to send a signal to financial markets about the certainty of their single-currency experiment. The sudden willingness to talk the talk on moving forward with “more Europe” is driven by the bank run unfolding in the region. Let’s review the latest unsettling banking data and other developments that will influence the outcome of this crisis:

(1) Bank run in Spain. According to data compiled by Spain’s central bank, foreigners reduced their deposits at Spanish credit institutions by 102.3 billion euros from a record high of 547.1 billion euros during June 2011 to 444.7 billion euros during March. In March alone, the outflow was 30.9 billion euros, and it probably accelerated during April and May.

(2) ELA propping up banks in Greece. The latest ECB balance sheet for May 25 shows a rise of 34.1 billion euros to 246.6 billion euros in “other claims on euro-area credit institutions denominated in euro.” This item includes the Emergency Loan Assistance (ELA) facility. Under ELA, the 17 national central banks in the euro area provide emergency liquidity to banks that can’t put up collateral acceptable to the ECB for refinancing operations. The risk of the lending is carried by the central bank in question, ensuring any losses stay within the country concerned and aren’t shared across all euro members. On May 17, the ECB confirmed it had moved some Greek banks onto the ELA program of Greece’s central bank until they are recapitalized.

(3) TARGET2 imbalances widening rapidly. TARGET2 is the euro’s cross-border payments system coordinated by the ECB with the participation of the national central banks. Floyd Norris did a good job of explaining how it works in his 5/31 NYT column. Prior to January 2009, the payments system was relatively balanced  However since then, the Bundesbank’s balance has soared from 133.7 billion euros to 644.2 billion euros as of April. That’s because deposits funds have poured into Germany (as well as Finland, Luxembourg, and the Netherlands) and out of the PIIGS, which had a record negative balance of 851.2 billion euros in TARGET2 in April.

(4) Money supply growth is slow and uneven. The TARGET2 balances are more or less consistent with the trends in M2 money supply measures over the past year showing that they are falling in Spain and Greece while rising in Germany. On balance, M2 in the euro zone was up 2.8% y/y during April. This suggests that while the area's depositors are moving their funds from the periphery to the core countries, they aren’t fleeing the euro. However, the recent plunge in the euro suggests that they may be starting to shift funds into the US dollar. Of course, the positive spin on a weak euro is that it should provide some lift to euro area exports. That might help to moderate Europe’s recession, which deepened during May according to the latest manufacturing PMIs.

(5) Important elections are ahead in France and Greece. Previously, I’ve observed that at the heart of the European crisis is a crisis of leadership. There are elections coming up that will determine whether the French government will be gridlocked and whether the Greeks can even form a government.

My friend Robert Hardy observes in his excellent The Geostrat: “France will hold elections on June 10th and 17th for the 14th National Assembly. The election will see 577 constituencies contested. The Conservative UMP party of former President Sarkozy now holds 314 seats to Hollande's Socialists' 204. It will be important to watch the outcome to judge the depth of Hollande's victory, and whether it was a personal repudiation of Sarkozy and his policies, or a real change of course. If the Socialists have a good showing it will increase France's power in the Eurozone.”

My hunch is that the UMP will succeed in denying the Socialists a victory. If so, then a period of "cohabitation" will follow. In this case, French President François Hollande won’t be able to deliver on many of his extremist proposals, and might be less of a pain in the derriere to German Chancellor Angela Merkel.

Recent polls suggest that the Greek national elections on June 17 will lead to a governing coalition led by New Democracy and Pasok. I don’t know whether we should be rooting for this outcome or not.

Today's Morning Briefing: Lake Winnipesaukee's Eight. (1) Almost as much fun as Ocean’s Eleven. (2) No retreat for the perma-bears. (3) From “Grexit” to “Spanic.” (4) The US economy is questionable again. (5) Fiscal union will make or break monetary union. (6) Europe’s ELA and TARGET2 showing bank runs. (7) Gridlock in France? (8) Shaving GDP in US. (9) Here come the Fed, ECB, PBOC, and BOE, again. (10) Time to buy? (More for subscribers.)