Bob's World: Happy Christmas, Cold Turkey Time
There are 5 things that really matter now: There are 3 'players' - the Private Sector ('PS') individuals, non-fin'l & fin'l corporates), the Policy Maker ('PM') (Govt., Central Bankers, Regulators), and the Financial Sector ('FS') (the Market, the big institutions); And there are 2 BIG defining 'forces' - Balance Sheets (incl. the Cost of Capital), and Growth (Final Demand). Each of these players and forces are linked to each other, influence each other, and rely on each other, in Good AND Bad ways. Let's take a closer look at each:
IMHO, the PS 'gets it'. They KNOW THEY BORROWED TOO MUCH, are suffering, and reacting by spending less, saving more and borrowing less. They are repairing their overly indebted balance sheets. This is a multi-yr trend in the face of employment/earnings fears, uncertainty around final demand, the certainty of higher macro-economic volatility, declining demographics, and confusing messages from PMs ('we have a major debt problem, so go out and borrow more!!!). The PS is Angry, Fed-Up with being taken for a ride (perceived, if not actual) all the time by the other 2 players, and seems to have lost its faith and trust in them.
They can see (or at least they perceive) the way the PMs have supported the FS - by running up a huge bill, the cost of which they KNOW will end up on their plates, but where there has been virtually NO TRICKLE DOWN of benefits to their levels. All they see, or at least perceive, is that the PMs and the FS are looking after each other, all at the expense of the PS. Losses are being socialised, whilst profits, on the back of PM support for the FS, are kept 'private'. The PMs and the FS have little credibility in the hearts and minds of the PS - there is little/no trickle down, there is no growth (other than a short-term cyclical bounce/pop, now long past) BUT there IS an enormous bill to pay. As a result the PS has, collectively, likely sub-consciously, changed its behaviour. PRUDENCE RULES. They know the tax bill is 'in the post' and that it is going to be big enough to lead to precautionary savings.
Note: Of course some folks love to consume irrespective, and how the 20 & 30-somethings react will be important, but the key for me, and where my view will be most right/wrong, will be in my bearish outlook for, and pro-prudence moves/behaviourial shifts by, the 40/40-plus year olds.
Note: Yes, as we expected, we have seen a bounce in measures like PMIs, equity indices and houseprice measures. But only from extreme levels and only based on miniscule volumes. This is NOT what 'Vs' look like. In Vs the breadth and depth of participation is high and self-sustaining, and is not reliant on (repeated) one-off policy shots.
The PMs, having been totally wrong thru all of 06/07/most of 08, finally 'got it' post-Lehman. They did a wonderful job of averting financial/economic hell. Great Job. But now they are seemingly reverting to type. They are persisting with 'systemic war-footing' policy even though that 'systemic' war is well and truly over. Amongst the PMs, the PS and the FS there is I feel, deep down, a realisation that persisting with such policy (debasement, monetisation, printing, borrowing) creates a huge risk of ANOTHER DEBT FUELLED ASSET PRICE BUBBLE, which depending on when it 'bursts', could be extremely serious and costly, whilst at the same time there has been VERY LITTLE TRICKLE DOWN of bubble gains to the PS. PM success post-Lehman is in part the problem. That success means the incentive now to delay policy exit is high - even though the post-Lehman systemic environment is now well and truly past - and that therefore the push will be to keep going for longer than is needed. But it is clear - an exit postponed is a bubble started/fed furiously. In this regard the responsibility cannot be with politicians to drive the exit agenda. This is the job of central bankers. Governments are accountable to voters, and election cycles shape their relative short termism. This is not the issue here. But the central banker leg of the PM triumverate is not accountable in this way and it has ALWAYS been, historically, the function and responsibility of central bankers to take the moral high ground and remove uber-easy policy BEFORE its too late. Greenspan did a very bad job at this. We must hope that Bernanke and King are neither too compromised nor too blindsided to the extent that they fail in this, now their KEY responsibility.
For now however central bankers seem all out of ideas - they are relying on the old failed policy of MORE and BIGGER asset bubbles in the hope that this equates to AND creates real and sustainable growth in the PS (spending, capex). Yet again the perception (at least) is that the PMs only care abt the FS as they see this as the only way to get Balance Sheets back in line (money illusion), and thus the only way to get Growth back to 'normal''. RECKLESS POLICY RULES, OK seems to be the PS mantra. Japan post-89 is, wrongly IMHO, seen as the benchmark for failed (ie, NOT ENOUGH) policy recklessness and thus used to justify today's environment. But folks seem to have forgetten that Japan had/has the benefit of huge trade surpluses and massive domestic savings - we have neither in the UK or US. In any case, there are just FAR TOO MANY BAD BALANCE SHEETS for this to work. And what's more, the reckless policy is creating the mother of all bad balance sheets, that of the PM itself. There are 2 choices. The current path - more debt, more bad balance sheets, more bubbles - is I think VERY MUCH the short-termist path and the WRONG PATH. If the current path is followed for too much longer, and esp. if it is stepped-up, it will be the worst possible outcome as the PM balance sheet will then be shot, and it will then force the PS to be EVEN MORE PRUDENT re their balance sheets. The other choice is Austerity. But the PMs seem not (YET) to have the WILLINGNESS to go down this route, which I think is inevitable. The more we resist and fight, the worse the end game. And guess what, in this regard, there must now be 'splits', even just in private, between perhaps Regulators and Monetary officials on the one hand, who can surely see where the current non-credible and unsustainable policy path will end up, vs Fiscal/Political officials, who operate with a different agenda. What EVERYONE should hope is that the great debasement experiment should be exited VOLUNTARILY, and NOT FORCIBLY because of PS and FS 'revolt' (USD/GBP crisis, massive spike in bond yields). Forcible exit is the path to ANOTHER Balance Sheet recession before the 1st one has been addressed, and will be hugely difficult to emerge from.
Financial Sector ('FS'):
The FS is confused. On the one hand, fears abound re Regulation and Comp. And lets get real. Comp is a critical factor in ANY, not just the FS, industry. It is being told to cut balance sheets and its reliance on the PM, is being told it will be taxed/broken up/regulated/see comp attacked/vilified, but at the same time is being allowed to use cheap money to BID UP FINANCIAL ASSETS, is being allowed to nowadays report accounts in a totally opaque way, and is being told to cut balance sheet yet also lend. Hmmmmm - Can YOU figure it out? Also EVERYONE knows that the vast pools on the buyside are index/benchmark based, and these folks are being sucked into buying when maybe they don't really want to - this is not my opinion, this is what buy-side real money accts are telling me!! All said and done, the FS continues to be ruled by the same 2 bad old emotions - Fear and Greed. Into 07/08, the FS was far too greedy. By end 08/early 09, the FS was far too fearful. And now, by end 09/10, the FS is again far too hopeful/greedy/wishful. It WANTS it all to be better, and is positioned for it. But deep deep down it is fearful that the great experiment being undertaken by PMs, esp. in the UK and US, will fail to PROPERLY repair balance sheets and AND, most importantly, will fail to get the PS growing again in a real and sustainable way. At which point the FS will be focused on the credibility and sustainability of the PM experiment and whether we need or should get MORE policy. The problem is, at some point, MORE policy becomes THE RISK, and NOT the solution. We are a lot lot closer to that point then most think. Why? Because we are a lot lot closer to the point where we realise that real & sustainable Growth is NOT coming and where we realise that the PS will instead spend YEARS fixing its balance sheet IRRESPECTIVE of what PMs may say or do. If and when the FS gets to the same thought place as the PS, the PM will be abandoned as non-credible. Ugliness would very quickly follow.
The Key Issue:
Folks talk abt the viability of fiat money or not, they talk abt deflation/inflation, they talk abt coming growth and valuations, etc etc. All such talks are, I think, 'subsets' of the same key issues: Are PMs willing AND able to keep printing/debasing/monetising, and, CRITICALLY, is it working/will it work. NOT in terms of short term artificial boosts to asset prices or brief cyclical pops in growth, but in terms of creating real and sustainable final demand/PS growth. PM willingness, esp. in the soft currency bad balance sheet countries is clear. But 'ability' is totally linked to the success/credibility/sustainability issues, and here it is clear to me that the PS has already voted NO. The FS is hanging on by a few threads, threads which 3/6 mths of consistently weak growth data (our expectation) would be reduced quickly to nothing much, at which point it gets real ugly. We are looking for ISM in the US to head down to the 40 area into y/e and in early Q1, with the unemployment rate up to 11%. At that point, the choice then for PMs is whether MORE policy is desired/gonna work/be do-able, or whether the inevitable, AUSTERITY, is then the right path. KEVIN fears more policy and then very quickly thereafter, thru the FS reaction - which we think would be deeply negative (much higher yields, much weaker currencies) in response to ongoing growth weakness and a serious spike in concerns re PM credibility - a second balance sheet recession which will lead to New Lows in stocks. IF more austerity is the response to the coming growth weakness over the next few months, whilst the initial kneejerk would be painful, over the course of 2010 I strongly believe this would be the LEAST BAD way out - it might take S&P to the 700s, but the MORE POLICY route would equate eventually to a 500-handle S&P. CREDIBILITY, SUSTAINABILITY and GROWTH are the keys - MORE POLICY does NOT in any way g'tee this, yet so many seem not to be able to see this.
We said in late Aug that S&P would get to 1100/1120 by end Oct/early Nov. We said growth would peak in Aug and then weaken (see above) into and in Q1. This is all playing out. As this plays out, I expect S&P to be in the mid-900s by y/e, and mid/low 800s by Q1 2010. Credit spreads will weaken materially, IG will do better than HY, QUALITY (strong balance sheets) will be the winner. I look for 750 Crossover by late 2009/early 2010, and then further weakness as Q1 unfolds. Govvies shud rally - I prefer BUNDS to USTs or GILTS. The USD will probably rally, but I dislike any currency where PMs are simply printing. GOLD please.GET DEFENSIVE RE RISK.
Thereafter, its all about the PM response.
MORE policy in the UK/US may help risky assets very briefly (2/4mths), but because growth weakness in the PS is/will be a sustained feature (IMHO) for many many quarters, MORE policy will very quickly be seen as THE risk. The USD and GBP would then be at huge risk as (PM) CREDIBILITY, SUSTAINABILITY and LACK OF SUCCESS are exposed badly. Bond yields will then rise dramatically I think - NOT because of bogus CPI inflation, but because debasement/monetisation will be seen as FAILED POLICY and which will then be PUNISHED, as opposed to the current outcome, where such policy has so far been given the benefit of the doubt and 'rewarded'.. This will lead to a truly ugly 2010 with New Lows in stocks (500-handle S&P), New/Near New Wides in HY, IG spreads another 50% wider. The EURO and the Bund are where to be in this world, as well as the HIGHEST quality balance sheets in credit and equity land (global big caps). Gold goes to $1500. THINK ABOUT IT - this is the world where USTs, GILTs, the USD, the GBP AND risky assets ALL SELL OFF.......This will also be the time to consider going massively OW USD/GBP, as well as OW USTs/GILTS. Why? Because 2010 and beyond will then see us FORCIBLY abandon Reckless Policy (the driver of the sell off) which would then quickly be followed by a new era of DEFLATION and AUSTERITY.
IF the PM response to the initial weakness over the rest of 09 and early 2010 is NO MORE POLICY, then the initial knee jerk will be +VE for the USD, the GBP, USTs and GILTS. The knee jerk will also hurt equities (S&P in the low 700s) and credit spreads (again, HY/bad balance sheets do worse than IG /Good balance sheets). BUT within mths, we will ALL LEARN TO ADJUST AND REPAIR OUR BALANCE SHEETS. The NEW Normal. 3/5yrs of US/UK GDP around 1%+/- 50bps and mild deflation/low inflation. A long period of REPAIR, REFUELLING, etc. This is the LEAST WORST OUTCOME. I really really really hope this is what we get. I FEAR, and Kevin expects, the dreaded MORE POLICY route.
A lot of moving parts, but the keys are balance sheets, real & sustainable growth/final demand in the PS, and the issue of MORE or NO MORE policy. As I say, I think the PS has made its decision. I hope PMs voluntarily MAKE the next decision (austerity) rather than being FORCED into making that same decision due to the FS 'revolting' against what it then decides is non-credible, non-sustainable and failed policy.
Note: Quick word on Money Illusion and why those of you who feel the 'way out' is ongoing reckless policy should be careful. Pull out a 10yr chart of the FTSE and/or the S&P. You will see that in NOMINAL TERMS UK and US stk mrkts are STILL lower than 10yrs ago, and of course the picture is much worse in REAL or hard currency terms. Turn these 10yr chrts from their local currency denomination into a hard currency like the EURO. You will see that in real EURO hard currency terms, US and UK equity mrkts have lost you almost 50%. Not good. SO YES, more debasement may create SOME money illusion and may stop the FTSE/S&P from hitting the 'real' lows, but nevertheless I see SIGNIFICANT losses ahead thru a combo of FX and nominal weakness. THUS - if you HAVE to be in equities, AGAIN the message is to focus in on hard currency strong balance
Near term I think the battle will be between Central Bankers, who deep down, and I think privately at least, FEAR bubbles, FEAR failure and FEAR FORCED abandonment if current policies are persisted with too long and/or added to, vs Fiscal Authorities, who by definition want short-term fixes (there is after all an election cycle in the UK & in the US next yr). This is like a rumble in the jungle between the VOLCKER-ites and the GREENSPAN-ites, with GREENSPAN representing the Fiscal Authorities (he was after all surely the most politicised central banker ever). Are the Volcker-ites up to a fight? I think so. I hope so. Kevin feels and I FEAR however that they aren't/they won't. In which case MORE policy and then, very soon thereafter DISASTER, will follow. In this rumble the inevitable outcome is deflation and multi-yr austerity. China will be the Ref in the boxing ring. The PS and the FS will be the Judges (who have I fear have already made up their minds (PS) or are soon abt to (FS)
Let's see, but the one thing that I'd say to Bernanke and King - the modern day Volckers (it would be unfair to expect, but great, if the real deal himself stood up and did it again, but I fear he is too old, so Ben and Merv are all we've got, along with buddies like Axel at the ECB) - is that even though he was knighted for his services to short-termism and bubblelicious ponzification, Greenspans legacy - measured objectively, not in terms of cash USDs receieved for public speaking etc where he has been very successful - IS in the sewer. When it comes to legacies, the REAL ECONOMY/MAIN ST./the PS is what counts, and the lesson of history is crystal clear on this. Volcker Won, Greenspan Lost. Simple as A, B, C!
Longer term it is CLEAR we need a lot more smart regulation, not just re the size of banks or banker comp., but of the whole FS. We must never allow the gross misallocations of capital of the last 2 decades to happen again. Wall St. must SERVE/SERVICE Main St., and NOT the other way round. This is the other clear lesson from the failures of the last 20 years.
Chief Markets Strategist
RBS Global Banking & Markets
135 Bishopsgate, London EC2M 3UR