From Bob Janjuah of Nomura
Time to fade Jackson Hole
This is the third piece that I have written since arriving at Nomura, the first was released on 22 October, the second on 1 December. I will first discuss the key themes that we feel are likely to drive global macro markets this year, and then will provide a tactical update.
Major macro themes and issues
1 – How will Asia and the EM bloc address domestic inflation and asset bubble concerns? Will we see a slowdown? Will any such slowdown be classed as a hard or soft landing outcome, and when? Does an EM slowdown, particularly one driven by China, India and Brazil, have global implications?
There are many questions and, based on wide-ranging discussions with many investors, many answers. Our call is that activity in Asia and the EM bloc will slowdown this year (and next) to combat inflation, asset bubbles and positive output gaps, with GDP growth rates off by about a third. This would be a soft landing, but one that would adversely affect the global economy directly and indirectly. In particular we expect growth in capital goods, capex and infrastructure investment to slow in these three big economies, which would not only affect domestic growth, but also growth in the big beneficiaries of these specific global growth drivers over the last two years – the commodity suppliers and the capital goods exporters. Germany, Japan, Australia, Canada and Scandinavia come to mind. The bulk of marginal global demand growth in the last 24 months – some 75% of it – has come from the big three EM economies.
We think the risk is that Asia and the EM bloc choose growth over the prudent and credible management of inflation and asset bubbles. Such an outcome might be welcomed by short-term traders, causing risk assets to “melt-up” in the short term, but we think it would almost certainly lead to severe hard landings in the EM bloc in particular, but also risks the global economy too, as we move into H2 2011. The next few months will we feel tell us much about the multi-month outlook for Asian and EM growth.
2 – Are we closer or indeed close to a “solution” for the European sovereign debt problem and the closely connected European financial sector capital inadequacy problem? In recent days the ECB and eurozone politicians have enjoyed some considerable successes, but we have already seen many battles – most of which have to date been lost by the ECB and eurozone politicians – in the bigger war that is being fought for the future of the eurozone. As such, we think another round of crisis, perhaps triggered by coming political changes in Ireland, is a very high risk.
Notwithstanding all this, we think that we are now closer to a long-term resolution for Europe's excess debt/inadequate capital problem than at any time in the last year. We are heartened by the now seemingly clear understanding among eurozone policymakers that the ECB must be extracted from its current role, where its true and pure mandate has been tossed aside. Many policymakers now seem to accept that the credibility of the euro is dependent on an independent ECB resuming its single (inflation) mandate. They also now seemingly realise that the eurozone does not have merely a liquidity shortfall, but rather an excess debt/inadequate capital problem. We think fiscal solutions are critical – not liquidity solutions. The current consensus now seems to be that the heavy lifting needs to be done via the EFSF, not the ECB. As part of this, a common eurozonewide fiscal policy, with automatic checks and balances, with Germany in the middle, seems to also to be accepted by eurozone policymakers as a necessary reality, even if acceptance of this is difficult for some, in terms of giving up of sovereignty. This is a leap forward. Some socialisation of losses is a given, but there also seems to be a growing understanding by financial markets and eurozone policymakers that some sovereign and (senior) bank bond restructurings are inevitable. We think that it is important that any such resulting loss recognition needs to be orderly and not systemic. In this context we think a major and timely recapitalisation of the European financial system will be critical to mitigate against systemic risks. Critically, talk of a eurozone break-up seems to have disappeared – in this context the November 2011 experience, in particular the way Italy and Belgium were dragged into the debt crisis – seems to have been the necessary catalyst. We think the genuine “fear of a break-up” that was increasingly widespread in November 2010 seems to have been enough to discourage eurozone policymakers from being so seemingly complacent and reactive, and instead shifted them towards being far more pragmatic and pro active.
We think the risk here is that we are placing too much faith on what we have seen and sensed from eurozone policymaker actions and words, as well as from talking to many market participants. Eurozone policymakers could revert back to old bad habits, and they may again believe that the problem can be delayed by doses of liquidity and debasement of the ECB?s balance sheet. Hopefully a sufficient number of European policymakers will look at the Greenspan and Bernanke Feds, where the primary solution to excess debt and asset bubbles that keep bursting is to increase debt and liquidity, and will judge that Europe must not go down this route. One key reason why the US has been able to do this for so long and so often is that, unlike the euro, the dollar benefits from its reserve currency status. We feel that this reserve currency status could change over the next few years. But if eurozone policymakers become complacent again and start to believe in liquidity-led “solutions” that seek to defer the difficult decisions on the excess eurozone debt problem into future years then in our view the euro is unlikely to enjoy reserve currency status. More importantly perhaps, the current lack of such status suggests that unlike the US, the problem cannot be delayed for too long without markedly higher levels of credit and market risk. But as mentioned above it may require another „interim? crisis before this is resolved. Either way though, this is all a story for 2011 - not 2013! We think the next few months are likely to be key.
3 – Is the US now on a path to sustained growth driven by sustained increases in domestic consumption, domestic capex, domestic job creation and domestic (real) wage increases? Or are we going through a redux of late 2009/early 2010? Think back a year - the market talk and statements out of the Fed (Bernanke included) was of sustained growth, exit from QE and even rate hikes! In Q2 2010 growth faded badly and we ended up with QE2. My message now is where would the S&P 500 index have ended in 2010 had QE2 not been forthcoming? I strongly believe QE2 added over 250 points to the S&P based on where it closed the year. I make this point for one simple reason. If growth fades in Q2 and Q3 2011, as we fear and as we saw in 2010, then we think the hurdle rate that has to be cleared before there could be any more fiscal or monetary boosts (QE3?) is now much higher than in 2010. This is partly because we feel President Obama and Bernanke's credibility will be damaged if QE3 is ever seen as necessary, partly because of the net hawkish changes to the FOMC voting member now versus 2010, partly because of Ron Paul in his new role as Chair of the Domestic Monetary Policy Committee, partly because of the Tea Party, which is looking to use their new power in Congress to reduce fiscal deficits, but mostly because we think the US electorate are clearly losing faith in its policymakers and policymaking institutions. We think confidence will hit new lows if, over the belly of 2011, the growth story fades, equity markets correct 10-20%, and/or if the unemployment rate inches upwards rather than falls.
I am not an economist, but as a strategist I believe there is a case for a multi-year period of weak growth in the US, which could be magnified by an EM slowdown as the EM bloc diverges policy to deal with its own domestic positive output gaps, domestic inflation problems and domestic asset bubbles. The obvious problem is that the US has an excess debt problem and a central bank that seeks to solve asset bubbles that burst by creating new asset bubbles. This policy has been proved a failure. Remember that debt does not equal wealth, that asset bubbles do not equal wealth, that more liquidity does not equal money but instead equals more debt, and that liquidity does not equal capital.
We think QE1 and QE2 have failed the real economy in the US at the expense of pushing up asset prices in financial markets, eg house prices vs. stocks. Most American families own a home, but most Americans do not own a meaningful amount of stocks. Bernanke's solution seems to rely on the US public buying into another round of bubble blowing and on the idea of trickledown economics. I doubt the US people will accept that. In fact, QE2 could be an own goal as we think it is going to increase the cost of food and energy for all US citizens without any corresponding increase in real wages. In the US, in the West, the headline CPI is a tax on consumption and is poorly correlated with the core CPI (which drives wages and which is non-existent). In the EM bloc core and headline CPIs are roughly the same - hence policy divergence between the US and EM.
Over and above the merits of QE, we think it is easy to argue that all the benefits of the December fiscal “boost” are (A) already priced in, (B) likely to be more than offset not just by rising headline CPI inflation, but also by the real economy drag from the municipal and state sectors, and (C) have already been largely offset by the net impact of QE2 - higher bond yields/higher mortgage rates. In addition we think it is unlikely that the household sector will run down its savings rate further, another spurt of inventory boost also seems very unlikely, the domestic capex cycle ex-structures and real estate is already at/close to multi-year highs, it is unlikely that the corporate sector will allow its balance sheets to lever up markedly again (corporate profit trends are at multi-decade peaks already), and the root cause of the majority of our problems – the US housing sector – is not about to turnaround meaningfully. If anything another housing (double) dip is much more likely, if not already under way. It seems clear to us that while Q4 2010 and part of Q1 2011 will be “strong” for growth, this is all already priced in. The next three to six months are going to be critical in terms of giving us a much firmer view of where the US economy is headed.
4 – Investor flows and sentiment are increasingly clear to us. There has been a gradual shifting out of EM and into DM (developed market) assets. There has also been a gradual shift out of fixed income and credit into equities. And while conviction levels are modest, where conviction does exist it is generally very bullish on the US, dismissive of the potentially global impact of an Asia/EM slowdown, and still mixed, but not as negative as it once was on the eurozone. Based on what we have seen and heard in client meetings, this biggest consensus and thus for us the biggest tail risk is the complacency on the US growth story. Second, is the dismissive attitude towards an EM/Asia slowdown. It appears that some investors genuinely believe that growth/inflation trends in China, India and Brazil are purely an asymmetric risk for us – that they only matter when they are powering ahead (going for growth) but when they have to slow down (to fight inflation) we can ignore them. We both feel that this is a very risky approach to global macro investing.
There is one other point worth stressing – is the multi-year bond/US treasury bull market over, and has a new multi-year bear market begun? The more nuanced view is "what level of US yields derails growth and risk markets?? We don't have the answers yet, but feel there are two things are for certain. If the US has to come up with more policy – fiscal and/or monetary – then the key global macro risk is the deteriorating credit standing of the US. If such concerns became elevated, we think US Treasury yields could spike much higher irrespective of where core CPI inflation may or may not be, and/or the USD could fall significantly. A good guide for this is the eurozone – the highest-yielding government bond markets are in those eurozone nations with the most powerful rates of deflation! In our view, core CPI inflation is currently a poor indicator of bond yields. Second, we both feel confident that bond yields (US Treasuries) are the key to the price of risk assets. Bernanke may believe that equity markets drive bond yields, but history suggests otherwise. Some clients have suggested to us that the sweet spot for risk assets (US equities) is when 10yr US Treasury yields are in the 2.5% to 3.75% area. In the past we have examined the correlation between core CPI inflation and equity returns and there does indeed seem to be a sweet spot when core CPI inflation is between 1.5% and up to about 3%. We will do some work on this whole issue, but the weakening relationship between 10yr YS Treasury yields and core CPI inflation in recent years makes finding a conclusion more difficult.
Trading and positioning recommendations
1 – Tactically we are now bearish and look for at least a partial reversal of the post- Jackson Hole QE2 inspired rally. Many technical and sentiment indicators are suggesting a 5% to 10% correction in equities (S&P500 from 1300 to 1220s). As I stated in my previous two pieces we were expecting risk assets to rally from mid-November through to early Q1 2011. My initial target on the S&P500 set in November when it was in the mid-1100s was 1220, and once we cleared and closed over 1220 for four consecutive days 1300, 1330 and 1350 were/are the next obvious targets. It has touched 1300, but has fallen well short of 1330 and 1350 – for now anyway. February may see the S&P500 grind up to 1350, and I expect the bulk of the tactically bearish repricing to occur in and around March and April. If it goes to 1350, and assuming that we do not have four consecutive closes above this level, my March/April target for the S&P500 (as a global risk proxy) is for a minimum 10% sell-off down to 1220, although my central forecast is for a correction of up to 20%, looking for the S&P500 to trade down to mid-1000s in during March/April. If there are four consecutive S&P500 closes above 1350, then we may be seeing markets enter melt-up phases (see below).
As discussed we expect the next few months to provide us with a lot of clarity on the outlook for Asian, EM and US growth, and the European debt problems and the US growth outlook. Based on these factors, current valuations and many other indicators, with S&P500 at 1300, tactically I recommend positioning for a risk sell-off now. I am happy to be short the S&P500 at 1300, with a stop at 1350 (closing basis, four consecutive closes). I would look to cover part of this short risk position down in the 1220s. If 1220 does not provide support on a closing basis, a much bigger sell-off (S&P500 down to the mid 1000s) would likely be next. Some clients see a 20% risk asset/equity market sell-off in 2011 as extremely unlikely. Views seemed to be the same this time last year, just a few weeks before the S&P topped at 1220 before dropping 200 points.
2 – In this tactical correction call, we think commodities and EM should sell off too, as should credit. One would also expect government bonds to rally and the USD to rally too. The most recent price action suggests that the correlations between risk, the USD and government bonds, which we have grown accustomed to in the last two years may be beginning to change. The USD in particular may be seeing a new phase where risk off is bearish the USD. For now we are trying to figure out what, if anything may be changing.
Our fear is a major correlation collision, where risk sells off (credit, stocks, EM and commodities) as do government bonds and maybe also the USD. What would then be the safe haven? For now, we are not sure but cash could be “king” again. We will revert with more thoughts on this but for now, the tactical call covering the second half of Q1 2011 and Q2 2011 is bearish EM, credit, stocks and commodities, bullish the belly and longer end of government bond markets, and slightly bullish on the USD. The government bond trade is likely best traded through curve flatteners (2s10s) in the UST market.
3 – The big risk to this tactical call is a risk market melt-up driven by Asia going for growth, and by evidence that the US is indeed in the early stages of what we would consider an economic miracle. In this scenario, covering the next few months, the S&P500 could easily rise by 10% or more and EM would surge higher, as would commodities, the USD would likely weaken, but perhaps only marginally so, but UST yields and government bond yields in general would rise significantly – perhaps to yield levels (such as 10yr USTs at 4%+) that “correct” risk markets. The risk of a market melt up is the key reason why I would trade our tactical bearish risk correction call with a firm stop loss on the S&P500 at 1350. In governments, we think yield curve flatteners in the UST market also seem to make sense in a melt-up scenario, with 2s, 3s and 5s likely to heavily underperform 10s and 30s. It is worth stressing that in our view any risk melt-up in say H1 2011 could be setting up a potentially very serious hard landing for the global economy and a very difficult H2 2011 for risk markets.
4 – We continue to believe that whether it is government debt, credit, EM, or equities, the secular asset allocation decisions still need to be driven by balance-sheet strength, with the preference being for strong balance sheets. Many of these happen to sit in the EM bloc. On a secular basis we also remain very bullish on the outlook for commodity prices. Of course in the event of a melt-up, and/or if one is much more bullish on the US economy in particular, then once should get long the most cyclical highest beta balance sheets in the US equity and (less so now) credit markets.
5 – Longer term, and as mentioned, we will need to assess the outlook for bond markets on a secular multi-year trend. Beyond any tactical timeframe history tells us that when we have the sort of debt-bust that we are working through, and when policymaker responses centre on more liquidity, more debt and more asset bubbles, then we should expect secular changes in the outlook for the cost of capital (simply put, higher bond yields) and/or currencies (currency regime shifts). The outlook for financial risk assets (stocks, credit, EM) are in such cases almost totally driven by such secular shifts, and almost always are a negative for risk assets. This is the primary reason why, on a multi-year basis, we remain so concerned about the outlook for risk assets, Western equities in particular, and why the levels of volatility and risk valuations of late 2008-early 2009 are still possible targets over the next few years. Policymakers may indeed have won a few battles recently, but the substantial real economy global imbalances and, in financial markets, the extremely fat tail (especially policy) risks that exist are not only being ignored, they are actually getting bigger.