Thursday, April 18, 2013

Time to Pay Attention to Macro Again

The Citi Economic Surprise Index (CESI) for the US crossed below zero this week. This is the second time this year it has done so. CESI is indicating that macro data is coming in below expectations.

A couple of points:

Global macro cycles tend to most often be highly correlated. You can see that in the first chart below. The red lines indicate periods where CESI in the US (top panel) has corresponded with downside data from the G10 economies. In the current situation, the US data is weakening at a time when G10 data has already been weakening for several weeks.

If you have been following treasury yields moving higher the past month and commodity prices moving lower this year, this should not come as a major surprise.

In late January, CESI for the US turned negative. In March, it turned positive again. Might this happen again now? It's less likely. In the same chart, note the black circles. The false breaks in US CESI have occurred when the G10 was stronger. That's not the case now.

What are the implications for US markets?

We have detailed these in a prior post. The main points are these:

First, US indices tend to follow CESI. JPM Morgan notes that the last 7 times CESI went negative prior to 2013, SPX lost 7% over the next 3 months. With ex-US markets largely flat to negative for 2013, it implies that the US might follow suit. Note that a 7% correction is not extraordinary; the median since 1980 is an 11% pullback each year.

Second, EPS correlates with CESI. In particular, downward revisions occur when the macro data weakens (second chart). We are starting to see this already with the 1Q EPS data, where bell weathers like GE and IBM are posting poorer non-financial revenues than expected. That is a particularly high risk for US markets, as expectations for 2Q-4Q EPS are exceptionally high even though evidence from the past 7 quarters does not seem to justify it (third chart). Sure enough, Bespoke says that, so far, 1Q revenues are beating by the lowest percent since 2008 (here).

Third, PE ratios tend to contract with lower growth expectations. That would mean lowered EPS with a lower multiple hits price twice.

Finally, treasuries tend to outperform. In fact, US treasuries have been outperforming SPX since CESI turned negative the first time in late January. That trend has intensified in the past month.

None of this at this point suggests the end of the bull market. But it does reinforce the message to lower expectations for the time being.