And Here Is Bob's New Prtnr In Crime: Introducing Kevin Gaynor
From Kevin Gaynor of Nomura
Enjoy the rest of 2010
Having been at Nomura for two weeks now, we feel we’re getting a handle on the current debate for markets and so it is time to set out some early thoughts prior to a major marketing trip when we hope to meet many of you and gather your sense of what’s next.
First, we present some of our long-held views that we still think hold value as a framework for considering the next big moves.
A brief history of our views
• Slowing western economies: In our view the crisis was principally embodied globally as a collapse in trade volumes compared with final demand. Re-liquifying trade finance combined with corporates being able to fund inventory out of cash flow rather than credit made for a whipsaw trajectory in especially, but not only, manufacturing industries. We judged that this would fade, with the level of final demand determining the end point. This has broadly been followed through.
• Balance sheets still matter: We went bullish on risk assets in January 2009 because we thought the potential for cash flows to surprise to the upside was being seriously underestimated and we judged the upside of the whipsaw in activity was ahead. But we didn’t feel the genuine recovery was at hand because those cash flows had to be seen through the prism of balance sheet rebuilding. In essence the Keynesian multiplier had fallen in the leveraged economies. Healthy balance sheet economies got the same stimulus and would prosper.
• Rebalancing is not happening quickly if at all: One suggested consequence of the crisis was that the infamous imbalances of the 2000s era would be addressed. It was never entirely clear how. It remains an open question as to whether any meaningful structural, rather than cyclical, rebalancing in current account deficit positions has or is taking place. As a consequence funding costs in debtor economies remain highly dependent on uninterrupted global flows and therefore good trade and political relationships across key borders.
• More policy not less: Bob and I began to highlight the potential for a second round of QE in the US back in May, effectively predicated on the idea that the surge in activity was set to wane, leading to stagnation in the labour market and mounting disinflationary pressures as substantial profit margin expansion was “invested” in price reductions. The Fed, fearing its zero bound problem and the potential for deflationary expectations becoming entrenched, needed to treat upside and downside inflation risks differently. However, it transpires that the Fed is not in a situation where it wants to ease from a cyclical macro-economic point of view rather than liquidity provision and shock and awe. It comes as no surprise to us that Bernanke’s recent speech fell some way short of “whatever it takes”. In essence this is not debasing – we expect that to be for QE3. The UK and euro area, with their quite different growth and inflation positions, would always lag the US by some considerable margin, not least because of the differences in their lag structures from growth to labour markets to wage setting.
Given the current and projected fiscal positions of most western economies, monetary policy has become the primary stimulus tool, although we should not forget old fashioned industrial policy (i.e. directly influencing the credit channel or setting prices) and regulatory tools remain largely untouched as yet.
• Inflation or sectoral price bubbles: The “inflation” issue is principally a commodity price issue. More QE would always be taken as further grist to the mill of commodity price inflation, in our view. Some might say commodities are one of the few markets left that are truly not under government control and so may be the purest way to trade reflation. We have a good deal of sympathy for this view – government bond yields are being increasingly set by central banks and FX markets remain open to significantly higher-than-normal intervention or restrictive capital account control risks. Nevertheless, the increase in commodity and food prices associated with the significant increase in central bank cash has led to differing extents to inflation coming through the non-discretionary price channel. This would normally lead to generalised price inflation via the labour market. In a weak labour market with modest wage growth it remains to be seen whether this channel just acts as a terms of trade shock for western consumers.
One attractive side effect for the US, however, is that any given change in global traded oil and food prices has a much higher impact on Chinese and other key EM countries’ inflation than it does US inflation. The Fed can therefore have a significant effect on domestic inflation in these countries and therefore force policy adjustments in those countries perhaps at a different pace than they might ordinarily have chosen.
• Evidence of a fall in trend growth in the leveraged West: We doubt that the sectors that grew the economy at its swift pace from the mid-1990s will repeat the feat for a considerable period. Employment growth rates in some economies moderated after the 2003 equity crash. As a result NAIRU rates have probably increased. Beverage curves, are showing very early evidence of a structural increase in unemployment. Capital scrapping in some industries, while healthy in terms of the ultimate adjustment, also suggests potential growth rates have at least temporarily fallen.
• Macro uncertainty high, discount rate low: Coincident measures of macro-economic volatility remain surprisingly high this far into a recovery. Theory would suggest this holds back irreversible investment decisions – which labour is in danger of becoming given increases in long-term commitment for non-wage costs. There is also some suggestion from traditional relationships that risk assets are not reflecting the current level of macro volatility. Perhaps more importantly, the moderation in growth and the issues highlighted above and discussed below about policy and global co-ordination risks suggest that the tails of the macro risk distribution are getting fatter not slimmer. Counter balancing this, and perhaps explaining the market’s ability to break with historical norms around volatility and valuations, is the plunge in real risk-free rates owing to central bank activity. As long as the discount rate remains under control then this may not be a problem, but thinking in a duration of risk assets mode (i.e. the price move of equities for a given rate move) we think this leaves the market rather vulnerable to a double disappointment of weaker-than-expected short- and intermediate-term earnings and a higher risk-free rate.
The Balance of Risks table below sets out the risks we are thinking about and assigns a probability and impact rating to each one for the next six months. You may have different concerns and assign different probabilities and rankings from the ones that we have identified – we hope to be able to debate these with you over the coming marketing tour.
We see the fact the Fed is acting early as good news in the general scheme of things, i.e. we welcome more policy rather than less. Or to put it another way, asset reflation is much more acceptable than asset price deflation. This appears to have worked. The first principal component of cross-asset class returns in Figure 1– normally an excellent leading indicator for activity and risk asset conditions – shows a very handy tick up over the past four months just when the actual leading and coincident indicators of global growth are still moderating from the post-crash highs.
In that sense, then, the actions of the Fed have “headed off at the pass” the negative impact of slowing growth expectations turning into acceptance of stagnation and increased structural unemployment. The Fed also helps out others around the world who may also be concerned about their own growth prospects but either are unable to implement further fiscal stimulus or do not have enough inflationary cover to go for early QE.
So, the world looks to be a better place for now. But it seems to us that rather than solving the underlying final demand issues in the leveraged western economies, this approach just moves the dénouement down the road. And there are, to use the polite economics word, externalities to the Fed’s action which at the very least increase the political tensions around a genuine attempt to rebalance. We think on balance that this sets us up for a bigger fall than otherwise six months out.
This note presents our views into the New Year, and we will of course be back with more detailed analysis and ideas as we settle in at this exciting firm.