Is the rise in US consumer confidence another sign of decoupling?

Friday we saw more evidence of a potential divergence between the US and the EU economic trends (see this post by Cullen Roche for more on the topic).

NYTimes: - Consumer sentiment rose to its highest level in more than four years in May as Americans stayed positive about the job market, while higher-income households were optimistic about wage increases, a survey released on Friday showed.

The survey, the Thomson Reuters/University of Michigan’s index on consumer sentiment, rose to 79.3 from 76.4 in April, topping forecasts for 77.8 and an initial May reading at the same level.

The reading, the final one for May, was the highest level since October 2007.

US vs. EU consumer confidence indicators

Unlike with the earlier signs of decoupling, the US equity markets remained skeptical and ended lower on the day. There are a couple of reasons for this:

1. The Eurozone problems are becoming so severe, it is now harder to see how the US could fully decouple.

2. The US consumer sentiment has been known to shift  rapidly.

NYTimes: - “Unfortunately, consumer confidence is still extremely vulnerable to a reversal, as occurred in the past two years,” the director of the survey, Richard T. Curtin, said in a statement.

Interestingly, the US consumer confidence indicator trend seems to have also diverged from the consumer sentiment in China. China's consumer survey results have been fairly volatile recently and more data will be needed to establish a trend. Given the impact of the US consumer on the economy and China's goal of increasing domestic spending, these relative trends will be tracked closely in the coming months.

US vs. China consumer confidence indicators

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German decoupling may have been wishful thinking

The concept of German decoupling from the Eurozone recession may have been wishful thinking. The latest German Manufacturing Purchasing Managers' Index (PMI) has converged with that of the Eurozone as a whole. Manufacturing PMI is a closely watched index and tends to be a leading indicator for the GDP.

German (white) vs. Eurozone (orange) Manufacturing PMI (Bloomberg)

In response, Spain's 5yr sovereign CDS hit a new record high of 511bp (previous high was 510 on 4/16).  The Eurozone is headed for a double dip.

Spain 5yr sovereign CDS (Bloomberg)

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Can Germany decouple from Eurozone's "double-dip" recession?

Source: TheLocal

Staying on the topic of sentiment indicators, let's now turn to Europe for a quick look at Germany and the European Commission Economic Sentiment Indicators (ECESI). ECESIs are monthly indicators that use business and consumer surveys to assess the levels of economic "optimism". They combine current conditions as well as expectations (similar to the U Michigan index for US consumers.)

EC: The monthly economic sentiment indicator reflects general economic activity of the EU. This indicator combines assessments and expectations stemming from business and consumer surveys. Such surveys include different components of the economy: industry, consumers, construction and retail trade.

The chart below compares the ECESI Eurozone with the Eurozone year-over-year GDP. ECESI definitely seems to be a good leading indicator for GDP growth.

ECESI Eurozone vs. Eurozone GDP

Now let's look at the ECESI by country.  The index clearly shows Germany decoupling from France and Italy. If ECESI is a decent predictor of the GDP growth as the chart above shows, we should see German economic growth decouple from the bulk of the Eurozone. 

ECESI for Germany, France, and Italy

Another sentiment indicator of German economic optimism is pointing to a similar trend. It is called the ZEW Germany Expectation of Economic Growth (computed by ZEW, a German nonprofit center for European economic research). The chart below shows the index net change. Just as was the case with the U Michigan Consumer Expectations index, ZEW is based on survey of expectations, while current conditions measures may not necessarily indicate economic expansion.  Therefore one should be cautions when interpreting movements in this index.

ZEW Germany Expectation of Economic Growth

Nevertherless the surveys are pointing to a potential for Germany to avoid a "double-dip" recession, which is inevitable for many other Eurozone states.

ZEW: On average the experts estimate a likelihood of 71 per cent that the German GDP will grow during the first quarter 2012. If this comes true, Germany will not slide into a recession for the time being. A recession – speaking in technical terms – does only exist if the quarterly GDP decreases for two consecutive times.

Here are five reasons that may explain some of this economic optimism in Germany.

1. Mild winter has helped German construction industry from shutting down.
2. Similar to US firms, German companies have restructured since 08 and are in a much better position to withstand a Eurozone downturn.
3. Public finances are generally healthy (better than the situation in the US) - for now.
4. German domestic demand continues to be strong.
5. The weak euro is helping the export sector compete more effectively on the international markets.

Clearly risks to German economic expansion are tremendous, particularly if further assistance for periphery nations (via ESM or IMF) or German banks will be required. But if these survey based indicators are reasonable predictors of GDP growth, Germany may indeed achieve at least a partial decoupling.

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VIX vs. VDAX - partial risk "decoupling"

VDAX is the Deutsche Börse's (German stock exchange) equivalent of the VIX implied volatility index. Given the current conditions in Europe, it is worth comparing the two volatility indices over three "stress" periods.

1. VIX vs. VDAX in 2008-2009 - the indices were on top of each other.

"We don't have any subprime debt - so we we are in good shape" said an officer of Allied Irish Bank in mid 2008. "Oh s..t, we have lots of Dublin real-estate" said the same person a few months later when Irish banks were being bailed out. The point is that the US financial crisis quickly became the world's financial crisis and the indices were tracking one another.

"V1X" (orange) is the VDAX index (Bloomberg)

2. VIX vs. VDAX in 2010, early 2011. Two events that stand out are the first "Greek crisis" and the earthquake disaster in Japan. Both events were viewed as impacting risk similarly in the US and in Europe and the indices were again generally on top of each other. In fact during part of the "Greek crisis", US equities were viewed as somewhat riskier, with VIX slightly higher in the summer. For a short period in the winter with QE2 in full swing in the US, VIX was lower.

"V1X" (orange) is the VDAX index (Bloomberg)

3. This year as the crisis unfolded,  VDAX has been consistently higher then VIX.

"V1X" (orange) is the VDAX index (Bloomberg)

Even though the eurozone crisis is viewed as a global issue, the market is clearly now differentiating the risks inherent in the US vs. German equity markets. This is quite different from the two previous stress periods and could be viewed as a form of partial risk "decoupling" between the eurozone and the US.

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The steepening vol curve and more risk decoupling

Implied volatility continues to sell off, with VIX down 10% (of vol, not points) month to date. The sell-off is particularly strong for short-dated options as VIX futures curve continues to steepen. The chart below shows VIX futures one-day move along the curve, with the nearby contract coming off sharply.

(Bloomberg)

With bullish year-end calls, we continue to have a case of "cognitive dissonance" as risk indicators diverge.  Surprisingly this time we are seeing the decoupling of the USD swap spreads and the US implied volatility index.  The two-year USD swap spread is up 4 bp today, while VIX is down some 3%.  This indicates further decoupling of short term risks in equities from medium term bank funding risks.

(Bloomberg)

Given that funding risk is generally associated with banks, this divergence is also visible in the underperformance of the financial sector during the past week.  The chart below compares recent performance of XLF and SPY ETFs (financial sector vs. the overall market).

The broad interpretation here would be that Europe's problems may impact US financials, but in the short-term the US equity market risks have diminished.  Again if one disagrees with this fundamental view, this may be a good opportunity to put on a trade: for example long SPY puts, receive fixed on the 2-year USD swap, and short 2-year treasuries. 

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VIX and EUR swap spreads - two diverging risk indicators

Euro swap spreads have moved up materially today with the 2-year spread rising 6bp to 113bp - near recent highs. That is clearly an indication of financial stress. However another financial stress indicator, the VIX has been moving in the opposite direction (lowering put "responsiveness").

 VIX vs. 2-yr EUR Swap Spread (Bloomberg)

This divergence is  puzzling.  Fundamentally it expresses a "decoupling" between risks in the US equity markets and risks in the EUR interbank funding markets.  That decoupling is difficult to imagine because should there be a funding problem among European banks, it will definitely translate into risks in the equity markets.

Nevertheless the market is telling us that participants are pricing these two risks differently with continuing credit tightness in Europe not necessarily translating into a significant slowdown in the US corporate sector.  For those who feel the fundamentals don't justify such divergence, there is a trade in there somewhere.

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Brent and WTI - Going Separate Ways

Crude oil continues to march higher with WTI going to $102. Given the European backdrop, it's not clear what is driving this move.

WTI (Bloomberg)

Some attribute this to the reversal of the Seaway pipeline to take the oil out of Cushing, Oklahoma  over to the Gulf coast (Bloomberg). That may alleviate some of the storage problem at Cushing where WTI contract is settled (and is credited for depressed levels in WTI). That may explain some the move today with WTI up and Brent down.

Bloomberg

But the spread between the two has now narrowed to below $10 per barrel in the last few weeks. Is the pipeline story the only explanation?.

Brent-WTI Spread (Bloomberg)

There are also rumors of hedge funds reversing the long Brent-WTI spread positions.  Something else however has to be at play here. The US Midwest refineries are humming. Industrial production is up (up 0.7% in October). There is an argument to be made for some growth decoupling between Europe and the US that may explain more fundamentally this divergence in demand for fuel. More on that later.

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