Bob Janjuah On The Market: "Like Bulls In A China Shop"
From the exquisite stream of consciousness of Nomura's recent addition: Bob Janjuah, who luckily discovered he was far too smart to be held back by the D-grade bailed out banker-clowns at RBS (we can only hope Bob will next discover the carriage return button).
Bulls In A China Shop
Since our debut notes here at Nomura (see The Sceptical Strategists: Has anything changed? And Enjoy the rest of 2010) Kevin and I have been around the world seeing clients and it is now time to put pen to paper again. Kevin published his latest report on 29 November (see The Sceptical Strategists: Battle royal between the haves and have nots) and here I share my latest thinking, based in large part on what we have learnt during our travels. I am going to do this in reverse order, starting with our key trading and positioning recommendations, and then moving on to the major macro themes and
issues that we judge are currently occupying the investor community.
Trading and positioning recommendations
Following the same format as our first note, we review our previous views and also look forward:
1 – Short term, the “buy the rumour, sell the story” theme seems to have played out pretty well. The reflation trade peaked in the few days either side of the QE2 and mid-term election announcements. This is clear from the performance of FX, equity, credit, bond and emerging markets. Part of the disappointment came from the scale of the QE2 package, which was much less than some market participants were hoping for. Part of the disappointment came from the credibility issues concerning the doves on the FOMC, including Bernanke himself. In particular, some clients thought the FOMC doves were almost too desperate to justify QE2 after the fact – and the credibility issues of the FOMC were not helped by the release of the FOMC minutes last week. The other big issue and driver of disappointment – other than extreme positioning for the reflation trade into the announcements – were the problems in the eurozone. Not just the Irish situation, but also the broader based worries about eurozone credibility.
2 – Beyond the shorter term, we judged that there would be a brief “risk on” phase from late November through to early 2011. We are less sure now for two main reasons. One is the issue of eurozone credibility and bailouts. The market now appears to share our view – that the eurozone is facing not a liquidity crisis but rather a solvency crisis. And in this respect the market – since the Irish bailout – seems to be realising that the bailouts and linked austerity are neither credible nor beneficial to the eurozone as a whole. After all, the logical extension of the bailout route is to damage and put at risk the hard-won inflation credibility of the Bundesbank and ECB, faced with a booming Germany and a very weak periphery. The ECB is now perceived as so compromised that it is unclear how it can now raise rates if Germany continues to power ahead. At the same time, it must now also be clear that if Germany and the other core countries are now back-stopping all credit risk from eurozone peripheral sovereigns and their banking sectors, then the Bund must now be seen as a risk asset and its yield must reflect all the credit risk it (the Bund) is meant to back-stop. This is not a situation which Germany and the other core countries are likely to accept in the medium and long term because now Spain and possibly even Italy and Belgium may be dragged into the mire. We have long been fans of BTPs and Tremonti, but the Irish “solution” – in particular the lack of credibility – could undermine the whole eurozone, not just the four well defined peripheral nations. Our second major concern is price action, where the S&P500 index is our global risk proxy. During the run-up in the reflation trade earlier this month the S&P500 yet again failed at 1220. This was the point of failure back in April, which was followed by a near 20% fall. It failed again in November. It did exceed 1220 but we always look for key technical levels to be cleared, on a closing basis, for four consecutive days. The move above 1220 failed to last beyond three consecutive days. It may be premature to talk about a double-top in (Western) equities, but we think the risk is clear. Kevin and I still think that the trailing data from the US and Germany may continue to surprise slightly to the upside over the weeks ahead, and we may see enough out of the eurozone, after the negative market response to the Irish bailout, to (attempt to) placate the market's concerns (but it may be too little too late). In particular, the ECB may make further offers of help. Nonetheless, it now seems prudent to clarify the call over the rest of this year. For now, we see 1220 S&P as a formidable barrier and the burden of proof now is on the bulls and those who buy into a successful reflation trade. Given the current situation, we think that until we can clear 1220 S&P on a closing basis for four consecutive days, then 1220 S&P looks like a ceiling and risks becoming not just a double-top but also a potentially dangerous triple-top (if there is a little run-up over December). As such, unless we get this sort of clearance of 1220, then we think the risk reward does not favour a bullish outlook nor any joy for the reflationist camp. Over the next week or so, we see 1130 S&P as some form of floor. If this floor does not hold, then there could be a repeat move back down to low 1000s S&P. The implications are clear for the reflation trade, in FX (USD positive), bonds (front end UST positive), credit/euro periphery (wider) and EM (negative risk assets) – it will be “risk off” time. Between 1130 S&P and 1220, we are range trading the reflation trade so recommend light and liquid positioning until there is a break out one way or the other.
3 – Beyond 2010 and focusing on 2011, we remain negative on the reflation trade and favour a “risk off” stance to markets. We are concerned about global growth. We are concerned that policymakers are running out of credibility, ammunition and the support of their electorates. And we are concerned that policymaker interests around the world are now diverging. One of the great successes of our times was how, globally, all policymakers seemed to get on the same page in response to the 2008 crisis. It now seems to us that serious divergences have set in, both in Europe (Germany vs the periphery) and globally (the US vs EM). This is a worrying development. For asset allocation purposes we recommend caution with respect to risk assets, bullishness on USD and the front end of the US curve, and any long positions should we think be driven by one primary rule – favour strong balance sheet entities, whether looking at equity risk, credit risk, government risk, FX or EM. For avoidance of doubt, based on the Irish bailout and assuming that the bailout route is the preferred policy choice in the eurozone (for now), we no longer see Germany, the euro or bunds as safe havens.
Using balance sheets as an asset allocation driver may not result in absolute return success, but should allow relative return outperformance. One final point to add: in the context of asset allocation for 2011 and in the search for strong balance sheets, do not forget Japan. Japan has one of the safest and strongest private sector balance sheets around – including the banking sector, which has been in balance sheet repair/risk reduction mode for nearly rwo decades now. And the balance sheet strength of the consumer and non-financial big cap corporate sector is well understood. We would also stress that while weak growth, persistent budget deficits and high public sector debt levels may be long-term issues for Japan, for now and for the next few years at least Japan is not a sovereign credit risk to anyone in our view. Simply put, Japan funds itself, and the country's substantial foreign net asset position means that this self-funding is under no real risk for the next few years. The real issue rather is that if Japan has to repatriate capital from the world to fund itself, then this is a far bigger concern for the rest of the world. Why? Because the rest of the world has grown very used to relying on these “cheap” Japanese capital outflows to fund itself. Should these outflows from Japan reverse meaningfully, the cost of capital to the rest of the world would surely rise – a potentially significant negative for the risk on/reflation trade.
Major macro themes and issues
Based on our travels, we see the following as the key themes and issues in the macro space:
1 – Emerging policy divergence: There seems to be a divergence in policy between the strong balance sheet surplus nations and the weak balance sheet deficit nations. The surplus nations seem to have realised that the deficit nations have structural, not cyclical, problems which will require a long period of balance sheet repair and economic reform. As a result, the growth/trade dividend that the surplus nations enjoyed from funding the deficit nations now seems far less certain and therefore, the desire to keep providing cheap funding is, we think, weakening. The net result is that the cost of capital to the deficit nations is likely to rise. And it means that the surplus nations may have to address domestic overheating/inflation/asset bubble problems even at a time when growth in the deficit nations is still very weak.
2 – Asia/EM slowdown: We expect a voluntary slowdown/soft landing in Asia/EM, as this block – which has driven global growth for some time now – deals with domestic inflation and asset bubble concerns. The QE2 move by the Fed has not gone down well in the Asia/EM complex as it has turned a long-term imbalance problem into an immediate and acute short-term concern for Asia/EM. We saw no signs of any sort of meaningful currency adjustment in Asia – rather, domestic tools like higher rates, low lending volumes and higher reserve requirements have and will likely continue to be used to achieve a slowdown.
3 – European concerns: We see two key themes around Europe. On the one hand is Germany's impressive growth this year. And on the other are the extreme problems of the periphery. The common link is of course Germany and its willingness and ability to keep funding its deficit nation brothers. As we have said before, we see two possible outcomes for the eurozone: (1) it ends up as a “hard” bloc dominated by prudent German policy, a clean ECB, and where burden sharing/bondholder losses (sovereigns and banks) and a centralisation (federalisation) of sovereignty are a harsh reality; (2) it ends up as a “soft” bloc where Germany underpins all credit risk and funding needs for the entire bloc – sovereigns and banks – and where the ECB is significantly compromised. For us the right long-term choice is clearly the former, but the Irish bailout suggests the opposite is more likely – for now. If this were indeed the long-term outcome then Bunds and the euro would certainly not be safe havens nor good stores of value. We use the term “for now” because we struggle to see how Germany will accept higher bund yields (as it increasingly has to reflect eurozone credit risk, not just German prudence) and higher domestic inflation (to help the peripheral nations, relatively, deflate) for any material period of time. The real issues for us now are (1) how generous will Germany be as the Asia/EM growth slowdown hits the German growth story? and (2) how generous will Germany be if Spain and even nations like Italy and Belgium are dragged into the mire. We think burden sharing/debt restructuring in the eurozone – and in other weak balance sheet nations – particularly (on a case-by-case basis) for bank bondholders, even at the senior level, are going to be both necessary and likely. And we think 2011, not 2013, is going to be the year that this hits home. It is worth repeating that burden sharing is likely not just to be a eurozone issue.
4 – US policy limits: There seems to be a general perception among clients that “if QE2 does not work, the Fed will do more.” We are uncomfortable with this. Bernanke is already struggling to justify his current policies and this struggle is not just with the surplus nations. Within the US concerns seem to be growing, including within the FOMC and Washington, that current policy settings are not appropriate and that something different (more Austrian) needs to happen. One of the biggest risks we see for 2011 is that we might be faced with a double whammy of a global growth slowdown, driven by Asia/EM, at precisely the same time that the limits to “more policy” in the US are hit, both fiscally and on the monetary side. We have no doubt that if things get bad enough, with say unemployment heading back well over 10% and/or the S&P 500 at 30-40%, then there would be some sort of Fed/FOMC/Washington consensus around more monetary (QE3) and fiscal (new “New Deal”) policy, but we now see this as the main issue. Namely, the risk now is that in order to get meaningful additional policy stimuli, things are going to have to get a lot worse. In the interim, we think the biggest risk is to the credibility of Bernanke and his current policy setting, in an environment where the political will to allow him to do more is clearly under the microscope.
5 – Investor sentiment and positioning: Our view on the global investor base is that there exists a lot of concern, uncertainty and confusion. We do not think investors are ready or prepared for burden sharing, for a global growth slowdown, or for the realisation that we are close to the limits for more policy in the deficit nations, including the US. The eurozone is a real concern because more investors seem to be reaching the conclusion that the whole project and bailout policies are neither credible nor sustainable. There seems to be a tug-of-war going on between the unwillingness to accept bond holder losses/burden sharing, and the desire for credible, sustainable and clear solutions to the solvency problems in Europe/the deficit nations, as opposed to more debt/liquidity fixes. We think 2011 will resolve a lot of these issues, although they may drag on to 2012. If this is the case, we will probably just be storing up even bigger problems for later, because strong global growth seems elusive and unlikely to provide us with an escape route. Investors are increasingly seeing this, but do not yet seem ready to accept the solution.
As ever, we appreciate any feedback. And if you are wondering why the title "Bulls in a China shop", I hope that after reading the above, it makes sense: financial markets are very fragile right now, and any bullish risk-on phase seems to be based on very hopeful assumptions (“don't fight the Fed”; “beware animal spirits in the US”; “don't position against the US consumer”; “Germany owes us”; and lastly, “China will always grow at 10%”). We prefer to rely less on hope and more on hard reality and sensible and credible policies – even if they may mean more pain in the short term.