Bob Is Back, And Asks "Has Anything Changed?"
Bob Janjuah, the only man who had anything remotely interesting to say at RBS, and luckily left, is now back at Nomura, and is a leaner, meaner, kool-aid debunking machine. His inaugural letter is attached below. One complaint: what happened to all the abrvtns? Bob, that was ur sgntre style. The English here is just 2... krct. The pipl dmnd abrvtns.
From Bob, now at Nomura
Has anything changed?
Hello all, it?s good to be back. Kevin and I landed here at Nomura two weeks ago and we will be writing for the first time this week, ahead of a period on the road, where we hope to catch up with at least some of you. As we have been out of the loop for a few months, we will focus here on identifying what we think will be the key drivers of returns in the global macro arena over the next six months or so. We will set out what we see as the key issues, where we stand on some of these issues, and then wrap it all up with some global macro asset allocation ideas and trading recommendations.
Right now the market seems to be grappling with five key issues.
Five key issues in the Macro space
1 – Policy: Fiscally, and with respect to the problem economies (the US, the UK and (part of) the eurozone), we think additional stimuli are unlikely, with fiscal tightening and sovereign credit constraints/limits instead being the most likely outcome. So, bearing in mind where rates are, the debate is centred on additional quantitative easing (QE). Are policymakers willing and/or able to do more, and would such policy be successful? QE2 by the Fed, barring the details on scale and scope, looks like a given but we believe that in the short term it is pretty fully priced in. What is not a given is whether QE2 will succeed, and it is far from certain that if QE2 „fails? we will automatically get QE3. We have no doubt that the Fed, through QE, is able to drive certain financial market assets to elevated valuation levels, which can result in asset bubbles and increasing levels of systemic risk. The Fed has, historically, proved itself rather good at this. What we think is the key instead is whether the Fed can, through QE2, drive sustainable growth rates and sustainable increases in the price of the asset that really matters in our view – residential (and commercial) real estate. Here, the Fed?s track record (and for that matter the Bank of England?s) and the track record of QE as a policy tool in general is far from comforting. Further, has the market considered the changing political risks and how this may hamper future policymaker responses? In the UK it is unclear how secure the coalition really is as fiscal pain becomes a reality, rather than a talking point. And in the US the mid-term elections look set to see a swing to the right in Congress, the result being a Congress that is likely to be even more „anti-Bernanke? than has been the case to date. Let?s not forget that just getting Bernanke a second term was far from straightforward. Based on what we see at the moment in terms of market expectations and the consensus opinion, the risk of major policy errors is already high, and rising every day.
2 – Decoupling: Economies around the world are decoupling, but they have not yet decoupled. Over time – the next few years and decades – economies should decouple further and one day, most likely after Kevin and I have retired, we will be able to use the word „decoupled?. But until then the future trajectory of growth in the problem economies should continue to have a major macro impact. And with respect to the non-problem economies (for want of a better term, the emerging economies), the West seems to be attempting a policy that forces such economies to tighten (through currency adjustments). In a world short of growth and inflation is this really such a smart move? We think it is premature to expect these economies to shift the drivers of their growth from exports towards domestic consumption. Trying to force a meaningful currency adjustment on these economies is fraught with risk from a global macro perspective. If they refuse to adjust would it lead to serious protectionism? What if they do adjust? Could that not just import more input price inflation into the West, without a corresponding boost to domestic consumption in the emerging economies, and without any meaningful benefit to exports from the West? A key concern here must be that, for example, US policymakers merely end up squeezing the profit margins of the corporate sector through higher input prices in a world where pricing power/demand on the end consumption side remains weak.
The other decoupling is in the movement of financial market asset prices – how correlated are markets? Again we feel the right term is „decoupling, but not yet decoupled?. As such, when it comes to the global macro situation we are still in the „risk on, risk off? camp, although we do see a situation where some (emerging economy) assets have differing betas and convexity profiles, and thus differing relative value profiles. But if for example the S&P 500 were to drop 25%, we are pretty sure the Hang Seng Index would also be substantially lower and European credit spreads would be a lot wider. The „risk on, risk off? phrase would likely again be consensus market thinking.
3 – Balance Sheet Recessions: The market and policymakers still seem to be debating whether the problem economies are experiencing a serious balance sheet recession/adjustment or merely a deep, but not abnormal, cyclical recession/adjustment. As readers of our previous work will know, Kevin and I are firmly in the „multi-year? balance sheet camp. Deciding which type of adjustment we are going through will likely be a major driver of policy, and doing so successfully will likely determine policy success, and thus investment strategies and returns/performance. Of course if one is in the balance sheet camp, then correctly identifying which country sits where is critical. As mentioned above, for us the obvious problem economies, the ones needing the biggest adjustment, are the US, the UK and parts of the eurozone. The eurozone is a peculiar beast because it includes both strong balance-sheet economies (notably Germany) and some extremely weak balance-sheet economies (I will not use the term peripheral European economies as Italy is not one of these problem balance sheets). Thus the additional complication when assessing the outlook for growth, policy, policy success and successful investment strategies in the region is to figure out if Germany and its stronger brothers in the eurozone are strong enough to offset the weak eurozone balance sheets, and to figure out if ECB policy is driven by what Germany wants and needs (a Bundesbank-style hard money approach), or by what the peripheral economies want and need. This alternative would result in a „soft money? and compromised ECB, in our view.
4 – Growth/Inflation: For each of these two broad camps of problem and non-problem economies, over the next few months and years we see four outcomes: growth, with or without inflation; and no growth, with or without inflation. Different economies will end up „sitting? in one of these eight outcomes, and this should drive the medium-term investor?s asset allocation decision. Generally, good growth outcomes tend to favour risk, and no-growth outcomes are not risk friendly, especially if one also considers that ongoing policy support is likely to get more muted, not more aggressive. The more inflationary the growth, the greater the investment decision should favour nominal assets over fixed rate debt. And the more inflationary the no-growth outcome, the worse it is for risk versus high quality fixed rate government debt.
It seems clear that market performance is again largely being driven by QE2/liquidity, which has led investors to chase yield (I am concerned that I am still hearing the phrase „search for yield? – have we learnt nothing?) and which has caused a decent run-up in nominal assets/risk. However, we must not confuse this liquidity-driven price action with what is going on with real economy growth and inflation, nor interpret said price action as a leading indicator of policy success. The market collectively has made this mistake too many times in the past 15 years. Surely it must be clear by now that if policy (especially very experimental and polarising policy such as QE) does not succeed in creating sustainable growth and sustainable real estate price appreciation, then all it is likely to do is result in financial market asset price distortions and valuations that are not sustainable. As a result we would again be faced with elevated levels of systemic risk. This would be a serious policy error as it would result in unsustainable financial market asset bubbles. Looking back at the preceding paragraph, it seems to me that the market is pricing in a growth-with-inflation outcome in the US. The risk here, and the cheap hedge (although it may get cheaper), is to consider the no growth with no inflation, or indeed the no growth with inflation outcomes. Deflation or stagflation – neither is a good outcome. As mentioned earlier, what is also key is whether – in either outcome – policymakers are willing or able to do more (QE3). As highlighted above, we have our concerns here.
5 – Pricing/Expectation: Nobody can know for sure whether the market has rational expectations as reflected in market prices, or indeed whether the market has irrational expectations as reflected in/by asset prices. One can have an informed opinion on risk, but not certainty. No amount of charting and analysis will give you the answer, and we are not convinced whether such work can even help better inform one on the debate between risk and uncertainty. At the micro level, and in „normal? times, such analysis is clearly critical, the deeper the better. But in what I and many others view as abnormal times, and in the cross-asset global macro space, we have our reservations. Further, if we are right that the world is in an abnormal state, and focusing at the global macro level, then attempts to understand the issues in a linear way, with linear analysis, could lead to a serious misunderstanding of the battle between risk and uncertainty.
With all that said, a major concern right now is that we, as a collective market, are again looking at the world in a linear way – a world where policymakers and policy are viewed as „ahead of the curve? and „doing what is needed?. One where we think we know the risks and have them priced correctly. And one where the uncertainty premium is priced at or close to zero (we are not at zero yet, but we seem to be trending that way). Think back to the dark days of 2007 and 2008. Whatever one?s individual views, collectively as a market we assumed a level of certainty with respect to real estate prices, with respect to the levels and cost of leverage and liquidity, and with respect to the certainty that no big financial institution would fail. We all know how that ended. Today, the equivalent „beliefs? are that policymakers are ahead of the curve, that there are no limits to what policymakers can do, and that there is a certainty that policymakers know what they are doing and that they will achieve their objectives without any risk or without any nasty unintended consequences. The seemingly complacent way the market and the global macro community are viewing the US foreclosure issue is a classic concern for us. This potentially critical issue is for now being washed over by the broader liquidity-driven fest. If the market trends of the past few weeks continue, the cost of hedging against these benign/bullish assumptions should get very cheap. Deciding when and at what levels such hedges are cheap enough should be driven primarily by the growth outcome in the real economy versus expectations, and the probability the market places – as expressed through market prices – on the growth versus no growth debate in the run-up to resolution.
Trading and positioning for the key issues
We have tried to describe briefly what we think are the issues that should be at the forefront of investor thinking, as well as setting out our concerns based on a global macro, cross-asset approach, where market pricing is the ultimate definition of consensus opinions right now. Now we move onto some conclusions and trading recommendations:
1 – Shorter term, position conservatively for QE2 disappointment (‘sell the fact’). This means tactically positioning against the trends of the past six weeks or so. We are not looking for a major reversal in the risk on trade, rather a 5%-style move lower/weaker in risk/nominal assets, a similar-sized but positive move in USD, and a reversal of some of the 10/30s curve steepening and move higher in breakevens. In this environment we think we could see the current iTraxx Crossover index in the 500/525 area.
2 – Beyond the shorter term, we think the market will want to see evidence of both the „failure? of current policy and of the limits to additional policy going forward before we get any significant correction in risk/nominal assets in particular. This is likely to be the business of H1 2011. Between then and now (and beyond the short term discussed directly above) it seems clear the market „wants to believe? and thus we think that the positive run-up in risk/nominal assets can continue. We would not be surprised to see US equities hitting the highs of 2010 in this next (three months or so) run-up. This would then be the environment where hedging against the (current) consensus, which is increasing risk bullish, increasingly „concerned? about inflation in the West, and which wants to „believe? in policy/policymaker success, should becomes extremely attractive/cheap.
3 – In terms of geography, in a positive risk asset world we expect the non-problem economies (the emerging economies, Germany) to outperform the problem economies (the UK, the US). The concern if/when we switch to a sustained (as opposed to short-term) negative risk asset world – which we think should come the latter half of H1 2011 – is that valuations in the emerging economies may be more stretched than in the problem areas, and thus the ensuing price adjustments could be more severe. In the eurozone, the key for us is, as mentioned earlier, whether the region is to be viewed as a big peripheral problem block to which is attached a strong core of Germany and its close neighbours, or whether the eurozone is to be viewed as a strong core around Germany with an attached peripheral problem. Earlier this year, when the Greece concerns were peaking, the market saw it as the former. Now we think the market views it as the latter (hence talk of ECB tightening). For us the jury is out, but if current price action trends continue then it will become very attractive and cheap to hedge against any shift back in market sentiment towards the former market perception, and we now clearly have a roadmap of how the market would react to such a perception shift.
4 – So if we put aside the very short-term trading call, we are broadly positive, on a three-month basis, that the market will continue to run with the trends since early September. Namely, pro-risk, pro-policy and pro-policymaker, with a firm belief that the Fed can and will create broad-based inflation and maybe also some growth. On a six-month basis our major concern is that market sentiment will abruptly and completely flip. Why? Because by then we think it should become clear that current policy settings are not working (in terms of driving sustainable real economy growth and sustained real estate appreciation), that „more of the same policy? will be seen as non-credible, and because we will likely be pretty much out of any other policy options. Over the next three months we think the risk reward will become increasingly supportive of an asset allocation and trading strategy that looks to pre-position for this turnaround in market sentiment.
Kevin and I will, as mentioned, be on the road a lot over the next few weeks, but we will endeavour to provide updates over the next few weeks and months, especially after we have done a tour of clients, policymakers and other sources, all of which historically have been invaluable in helping us form our opinions and recommendations.