The federal deficit may well fall to around 4.0% of GDP in FY 2013

This represents a very rapid deficit reduction compared to what was generally expected. For the first seven months of the current fiscal year, the reduction in the deficit from a year before (1.6% of GDP) is already similar to the decline recorded during the whole fiscal year 2012 (see chart above). Therefore, it does not come as a surprise that two days ago the CBO (Congressional Budget Office) published sharply lower deficit estimates. For the whole fiscal year, the CBO now expects the deficit to represent “only” 4.0% of GDP, revised down from 5.3%, an estimate that was made yet not long ago (February).

Part of this forecast revision is linked to one-time special dividends that will be soon paid by the GSE’s (Fannie Mae and Freddie Mac). These payments to the Treasury may approach $90bn. However, other sizeable modifications were also made. For example, estimates of corporate tax receipts for FY 2013 were raised by 16% compared to the projections made in February. Just three  months after the initial estimate, this represents an astonishing revision. As the CBO considers that a good part of the budget improvement is temporary (that’s certainly the case for the GSE’s dividends), the revisions for the following years were much more modest. Nevertheless, the deficit for FY 2015 is now estimated to drop to 2.1% of GDP, revised from 2.5%.

Overall, we believe all these estimates are reasonable, although positive surprises remain quite likely. If there is one common international and historical feature in public finances it is that the impact of economic growth on budget deficits is most often widely underestimated, for the worst (when the economy falls into recession) but also for the better (when the economy recovers). Nevertheless, the improvement in federal public finances already recorded and projected looks spectacular. As a percentage of GDP, the deficit fell from a peak of slightly more than 10% in 2009 to 7.0% in 2012 and, as we have seen, it should decline to 4.0% in 2013 and around 2.0% in 2015.

The lower deficit has important implications

This rapid fall in the deficit over the recent past is very good news in itself, but also has important implications:

1. Next Sunday (May 19), the debt limit will no longer be suspended. Once again, the Treasury will have to take “extraordinary measures” to keep the federal debt below the limit. The good news from the context painted above is that the next debt limit deadline may well not occur before end-October. This means that potential political tensions around that matter are still a few months away.
2.  The improving financial picture also means that the need to take further measures to tackle the deficit is much less urgent. Politicians already seems to have become more flexible on these matters. Further budgetary tightening of one kind or the other is becoming less and less likely, at least for the coming year or so.
3. The surge in federal government tax receipts suggests that the economy may actually be stronger that what the official data are currently showing. Upward benchmark revisions to payroll employment statistics were one reason to expect that the extensive revision to be published on 31 July would show higher GDP growth rates for the past 1-2 years. Surprisingly, strong federal revenues are another reason to bet on that.

Heterogeneous figures in core countries
The two largest economies showed divergent trends. Germany avoided recession thanks to a slight increase of 0.1% q-o-q in Q1, weaker than consensus expectations (0.3% q-o-q). Meanwhile, the French economy contracted by 0.2% q-o-q, the second consecutive quarter of decline, meaning that France is technically in recession. As for the other core countries, Belgium (0.1% q-o-q) was the only country with Germany and Slovakia to post a positive figure in Q1, while GDP in Austria remained flat. Growth in the Netherlands and Finland fell, both by 0.1% q-o-q.

Peripheral countries trapped in a lasting recession
Periphery countries continue to experience negative growth, albeit at a slower pace than the previous quarter. Italian and Spanish GDP fell by 0.5% q-o-q, while Portugal recorded a fall of 0.3% q-o-q, a softer contraction than the -1.8% q-o-q recorded in Q4. Data for Ireland are not yet available.

No engine of growth
Eurostat does not provide expenditure breakdown at this stage. Nevertheless, the national data available suggest that the main culprit for the contraction seems to be investments. It would also appear that exports, which have been hurt by the recent slowdown in global trade, did not support growth in Q1.

First quarter GDP figures point to the longest-lasting recession
Latest business confidence surveys (PMIs, EC survey) suggest that recession will continue in Q2. With a weak recovery from Germany, subdued global economic growth and peripheral economies squeezed by fiscal austerity and a credit crunch, the outlook for the euro area is still gloomy. As a result, we maintain our below-consensus forecast of -0.7% real GDP growth for the whole of 2013 (consensus: -0.4%).

Too much optimism on financial markets?
Recently, disappointing economic figures were relatively well received by financial markets as these numbers fed expectations of further non-standard measures by the ECB. But now that Mario Draghi has disappointed and there does not appear to be an imminent major announcement from Frankfurt, that a proper economic recovery is still in sight, there is a risk that investors will start to wonder if they are not ahead of fundamentals and that equities in particular have recently discounted too much good news.

However, to take advantage of the rebound to cut the allocation to this asset class completely would be inappropriate. Instead, we have decided to adapt our funds of hedge funds to optimise their role in the portfolio.

In essence, the performance of an alternative strategy can be broken down into exposure to systematic factors, commonly called risk premiums, and specific factors, in other words the ability of a manager and team to add value in an asset class regardless of the performance of that asset class. This distinction between betas (dependent on market returns) and alpha (independent market returns) has led some to promote a management approach explicitly recognising these two components.

Under this approach, the portfolio is considered to consist on the one hand of a majority of traditional investments (bonds, equities, securitised real estate, etc.). The investor gains exposure through simple, liquid and cheap instruments: that is, exposure to betas. This exposure is then complemented by more sophisticated and expensive instruments that seek to capture alpha. In practice, and in the context of portfolios that cannot or do not wish to use leverage, this approach has the disadvantage of absorbing a lot of capital, leading to sub-optimal allocation of assets globally.

Our approach is to define our exposure to hedge funds by type of strategy and risk premiums. Specifically, we first exclude strategies where the risk/reward does not offer any advantage over traditional assets. We then combine attractive strategies based on the systematic risk premiums to which they are constantly exposed. Finally, we allocate these subgroups based on their complementarity with traditional asset classes, subject to the same risk factors.

To this end, we completed the restructuring of Pleiad by transforming a broadly diversified portfolio with low volatility to a concentrated portfolio of eight specialised managers in credit and distressed debt. This focus allows us to use Pleiad to diversify our allocation to credit risk in portfolios by optimising the capital allocated to these strategies, focusing on a limited number of managers with a clearly identified competitive advantage and optimising the costs associated with non-traditional investment strategies.

In an environment of zero risk-free rate of return and intense exploitation of anomalies to produce independent market returns, alternative strategies must more than ever be nested within the asset allocation as a whole, rather than considered separately as satellite around a conventional core of portfolio assets.

Part of this weakness was explained by a widely expected contraction in the production of utilities (-3.7% m-o-m), following a surge in March (+6.4%), amid exceptionally cold weather.

Nevertheless, the usually less volatile manufacturing part of production was also disappointing last month. It fell by 0.4% m-o-m, well short of the consensus expectation of a 0.1% increase. Moreover, March’s drop was revised for the worst: from -0.1% m-o-m to -0.3%. February’s strong rise was also revised down: from +0.9% to +0.7%. As a result, manufacturing production contracted by 0.3% annualised between December-February and March-April, compared to a healthy growth rate of 5.0% q-o-q in Q1 2013.

Following this set of weak numbers, growth in manufacturing production has converged on what was suggested by surveys, and notably by the output subindex taken from the ISM survey (see chart above). That was far from the case before today’s numbers were published.

Today’s set of statistics suggests that manufacturing output growth is behaving similarly to the broader economy. Q1 was strong overall with a distinct softening at the end of the quarter, a softening that continued into April. However, the back-to-back monthly contraction in manufacturing output witnessed in March and April should not be taken too negatively. Strongly influenced by inventory mini-cycles, manufacturing activity can fluctuate much more than the broader economy in the short-run. And the recovery in output seen between October and February was particularly strong: +2.8% (equivalent to an annualised growth rate of 8.7%).

Altogether, today’s data corroborate our scenario of a significant – but temporary – economic slowdown in Q2.

However, to take advantage of the rebound to cut the allocation to this asset class completely would be inappropriate. Instead, we have decided to adapt our funds of hedge funds to optimise their role in the portfolio.

In essence, the performance of an alternative strategy can be broken down into exposure to systematic factors, commonly called risk premiums, and specific factors, in other words the ability of a manager and team to add value in an asset class regardless of the performance of that asset class. This distinction between betas (dependent on market returns) and alpha (independent market returns) has led some to promote a management approach explicitly recognising these two components.

As expected following the sharp m-o-m decline in gasoline prices, sales at gasoline stations fell heavily (-4.7% m-o-m, following -3.2% in March). However, nominal auto sales rose by 1.0% (following -0.5% in March), a very positive surprise since already published unit car sales were suggesting a substantial contraction since they fell by 2.3% m-o-m in April. Meanwhile, sales of building materials bounced back (+1.5% m-o-m), following a 0.5% drop in March.

Control sales: surprisingly robust in April

In this context around the most volatile components of retail sales, it is interesting to look at what happened with control sales, i.e. sales excluding autos, gasoline and building material stores (the portion of retail sales that goes directly into consumption calculations). And actually control sales were also surprisingly buoyant in April: +0.5% m-o-m, above consensus expectations of a 0.3% rise. Moreover, the figure for March was revised up from -0.2% to +0.1% and February’s number from +0.3% to +0.5%. The end result is that core sales grew by a surprisingly robust 4.3% q-o-q between Q1 and April, following +3.8% q-o-q in Q1 and +4.3% in Q4 2012.

Although April retail sales figures were above expectations and past figures were generally revised higher, all the charts above nevertheless show a clear slowdown in growth in the main measures of retail sales.

Consumption growth still likely to show a distinct slowdown in Q2

However, the behaviour of retail sales in Q1 was – and remain – at odds with the strength seen in global consumption data (see chart above). Part of this divergence was linked to strong growth in consumption of services (and notably to a weather-related temporary surge in consumption of utilities). However, data on consumption of goods and statistics on retail sales remain hard to reconcile.

In the current statistical context, forecasting US second quarter consumption growth looks particularly difficult. For the time being, we still expect US consumption growth to slow from 3.2% q-o-q annualised in the first quarter to some 2.0% in the second (and GDP growth to around 1½%). However, the data published yesterday are putting some upward risks on this short-term scenario.

Factory orders surged again in March

Moreover, factory orders picked up by 2.2% m-o-m in March, much better than the fall expected by consensus (-0.5% m-o-m). The February figure was revised down slightly from 2.3% m-o-m to 2.2% m-o-m. Better flows were visible for both domestic and foreign orders, as they increased by 1.8% m-o-m and 2.7% m-o-m respectively. Overall, February/March data more than compensated for the disappointing January figures and for Q1 as a whole factory orders rose by 0.4% q-o-q, the second consecutive quarter-on-quarter increase (1.0% q-o-q in Q4).

March’s trade data improved

Trade data also showed an improvement in March. Indeed, exports rose by 0.8% m-o-m, worse than consensus expectations (1.5% m-o-m) and imports increased by 0.5% m-o-m in line with consensus expectations. It is worth noting that despite disappointing trade figures in February and weaker than expected data in March, exports increased by 0.1% q-o-q in Q1, much better than -2.0% q-o-q in Q4.

Hard data statistics may disappoint in the months ahead

March’s data suggest that German industrial activity has gained momentum over the quarter and point to a weak recovery in Q1, after the sharp fall in Q4. This notwithstanding, German economic activity remains fragile and recent business survey readings (PMI and Ifo) deteriorated in March and April, meaning that after better-than-expected readings March’s hard data statistics may lead to disappointments in the months ahead. Moreover, the yen’s recent sharp depreciation is likely to put pressure on German exports, as German and Japanese exporters work in the same market segments. As a result, German industrial production could suffer in the months ahead owing to this loss in competitiveness.

Slightly positive German GDP figure expected in Q1

All in all, March’s better than expected figures confirm our forecast for slightly positive German GDP growth in Q1 ( close to 0.2% q-o-q, Consensus: 0.3%). Official figures will be published next Wednesday. For the whole euro area, our Q1 GDP forecast (-0.4% q-o-q) may be overly pessimistic. At this juncture a -0.2% q-o-q appears more likely. If confirmed, this figure will take the euro area GDP growth forecast for 2013 to -0.7% from -0.8% (Consensus: -0.4%).

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As this series on job creation is often very volatile (see chart above), we should not read too much into short-term changes in job creation. Job creation has averaged 196,000 per month so far this year, a solid reading, similar to what was registered in Q4 2012 (209,000 per month on average). However, this kind of pace is not far above the average recorded during the ongoing cycle. Since the beginning of the recovery in employment (March 2010),  job creation has averaged 163,000 per month. Nevertheless, the good news is that with today’s numbers in hand, the fears of a slowdown in payroll gains that had appeared last month following the publication of March’s figures are gone for now.

The unemployment rate dropped further

The unemployment rate surprised positively as well. It moved down further from 7.6% in March to 7.5% in April, against consensus estimates calling for an unchanged rate (see chart above).

Moreover, this time around, the decline in unemployment was of the “good sort”. Unlike in March, the fall in unemployment m-o-m in April was linked to a sharp rebound in the employment measure of the household survey. According to this often very volatile statistic, employment rose by 293,000      m-o-m in April (following -206,000 only in March). The size of the labour force bounced back as well, but by less. It climbed by 210,000 m-o-m in April (but the participation rate remained unchanged at 63.3%), after a fall of 496,000 in March. As the change in the number of unemployed is the difference between the change in the labour force and the change in employment (210k minus 293k), unemployment declined by 83,000 between March and April.

The “payroll proxy” for labour income fell back in April

There was nevertheless a noticeable disappointment in today’s report. The average workweek fell back from 34.6 in March to 34.4 in April. As a result, aggregate private hours worked (which combines the workweek with employment) actually contracted by 0.4% m-o-m in April (+0.4% in March). Meanwhile, average hourly earnings rose relatively robustly: +0.2% m-o-m in April, in line with consensus estimates. Nevertheless, the end result was that the index of “aggregate weekly payrolls” (calculated as a product of aggregate hours worked and average hourly earnings) dropped by 0.2% m-o-m in April. Therefore, this index grew by 4.1% annualised between December-February and March-April, still a relatively healthy number, but nevertheless a much softer reading than was recorded q-o-q in Q1 (+6.1% annualised). As this index is a good proxy for household income coming in the form of private wages and salaries, it suggests that in spite of encouraging job creation figures, growth in labour income has lost momentum recently (see chart below).

Overall, today’s report was encouraging, mostly because it suggests there was actually no slowdown in job creation over the recent past. However, job creation was far from spectacular in April and the loss of growth momentum in household income coming in the form of private wages was certainly a disappointment.

Although today’s set of data will lessen market fears of a marked economic slowdown, we continue to expect growth to slow substantially in Q2 before regaining momentum in H2.

No clear guidance to unlock the credit crunch
A decision to buy asset-backed securities collateralised by SMEs loans would have been much more effective in improving loan conditions for corporations. The ECB’s attitude in this area continues to disappoint. The Governing Council still appears uncomfortable with the idea of taking on credit risk as Mario Draghi stressed that the ECB will not clean up banks’ balance sheets or finance governments. Nevertheless, the ECB seems to be resolved to revive the ABS market, notably ABS collateralised by SME loans. But the ECB is waiting for the European Investment Bank (EIB) to back such vehicles. It will therefore take several months more for an agreement to be reached.

Periphery stuck in recession
In the meantime, periphery SMEs will continue to struggle to find cheap financing. In all likelihood, economic activity will remain sluggish, in particular in the periphery, where the economies are unlikely to exit recession soon.

Sovereign bonds likely to be supported by bad economic news
These developments are likely to be favourable for the sovereign bond market. The handling of the Cyprus crisis has proved to the investor that taxpayers will be protected in future, as assistance programmes will be financed first through private creditors bail-in. This example has triggered a new regime that is favourable for sovereign bonds right across the board. Instead of adding stress, as was the case at the heart of the crisis, bad economic news now translates into lower bond yields on Bunds and also on periphery bonds. This regime  should not be interrupted by Thursday’s announcements.

The consequences are less clear-cut for stock markets. Recently, bad economic news was well received as it reinforced expectations of non-conventional ECB decisions. After Thursday’s announcements, though, equity investors could be disappointed, so this mechanism could be interrupted.

A 25bp rate cut, as expected
As had been widely expected, the ECB decided to cut by 25bp its main refinancing rate (Refi). The marginal lending facility rate (the ceiling rate) was also cut but by 50bp. As a result, the corridor was reduced from 0.75% +/- 75bp to 0.5% +/- 50bp. The narrower corridor is expected to further reduce the volatility of the EONIA rate (the overnight interbank rate).

The ECB ready to cut deposit rate below zero
When questioned about the deposit rate, Mario Draghi hinted several times that the ECB was technically ready to cut the deposit rate below zero and, as such, it was ready to act if needed.

He went on to specify that there was a “very strong prevailing consensus” for a rate cut and a “prevailing consensus” for the 25bp reduction.

In response to a query about the effectiveness of a 25bp rate cut, Mario Draghi stressed several times that the decision had been made easier by the fact that even core countries had recently been affected by an economic slowdown. However, he downplayed falling inflation figures published this week and gave the timing of Easter this year as a reason for April’s low figure.

Unlimited liquidity will be supplied, at least until July 2014
In addition to the rate cuts, Mario Draghi announced that the ECB would continue to conduct main and long-term liquidity supply operations (MROs and LTROs) as fixed-rate tender procedures with full allotment (i.e. all liquidity requested would be supplied at rates close to the Refi) as long as necessary but at least until July 2014.

Nothing concrete for SMEs
Aside from the rate cuts, expectations had been high that further non-orthodox measures would be announced, especially as far as easing the credit crunch affecting small and medium size enterprises (SMEs) was concerned. The announcement on this point was particularly disappointing, though. Mario Draghi said that the Governing Council had decided to start consultations with other European institutions on initiatives to promote a functioning market for asset-backed securities collateralised by loans to non-financial corporations.

After Benoît Coeuré’s speech on 11 April it was clear that the solution the ECB had in mind would involve several institutions (ECB, EBA, EIB, European Commission, etc.). However, as Mario Draghi has since the beginning of the year regularly mentioned the need to reduce fragmentation in the euro area (i.e. reduce the dispersion of lending rates across euro area members, notably for SMEs), it had been assumed that discussions for a practical solution were already well advanced and that a decision could be announced as early as June’s press conference. The announcement on Thursday has thus delayed any concrete decision for several months.

Mario Draghi happy with fragmentation reduction
Regarding fragmentation, Mario Draghi went through a long list of signs that there is some improvement. He highlighted in particular the increase in periphery bank deposits, ongoing capital inflows and narrowing Target2 imbalances.