The Four Scenarios For 2010
New report out of DB strategist Jim Reid highlights the 4 main scenarios for 2010 from the German bank's point of view. These are as follows:
- Scenario 1 – This scenario is the most optimistic and is one where the authorities have as good a year as they did in 2009. They likely keep stimulus extremely high in the system without there being any noticeable consequences of their actions (e.g. rates at the short and long-end stay low). Under this scenario we would expect equities to be significantly higher, credit spreads be much tighter but with bond yields only edging slightly higher as the authorities are seen to have firm control of inflation expectations and may even be continuing to buy bonds.
- Scenario 2 – This scenario is the most likely and suggests that we start to see gradual easing off the gas from the authorities but only as it’s proved that there is some momentum in the underlying economy. Under this scenario risk assets have a good year but returns are checked to some degree by rising bond yields and less stimulus being injected into markets. A satisfactory year for risk, especially equities, but a mildly negative one for fixed income. Credit investors will likely have to rely on spreads (and higher beta credit) to get positive total returns.
- Scenario 3 – This is the second most likely scenario overall in 2010 but one that potentially becomes more likely as the year progresses. Here we are likely to see sharply higher bond yields start to disrupt the positive momentum in markets. These higher yields could be either due to Government supply starting to overwhelm demand (especially as the impact of QE, and similar schemes, wane), or because of inflation fears. It seems unlikely that actual inflation will be a concern in 2010 but it’s quite possible for expectations to become unanchored. We would also have to include the potential for a Sovereign crisis somewhere in the Developed world within this scenario. We would note that the higher yields in this scenario are not based on positive growth momentum but by inflation/Sovereign risk. Such a scenario is incorporated in Scenario 2.
- Scenario 4 – This is the nightmare scenario of Deflation or in less extreme terms perhaps a double-dip. Given that much of the world is currently still in negative YoY inflation territory it is difficult to completely rule out even if we do live in a fiat currency system and even if inflation is expected to return to positive territory in early 2010. For deflation to be sustained we would probably need an exogenous event to hamper the authorities ability to continue to successfully fight this credit crisis. Such events could be a fresh banking crisis arising, a political backlash encouraging immediate increases in economic regulation or withdrawal of stimulus, or possibly a Government bond/currency sell-off that forces the authorities to aggressively reign in stimulus for fear of a sovereign crisis. A Sovereign crisis outside the Developed world could also encourage this scenario as there would be a flight to quality into Developed market bond market in spite of the fact that these markets have their own large fiscal issues. Bond yields would eventually rally strongly but risk assets would experience a very poor year. As time progresses this scenario becomes less likely as the system gradually repairs itself and the authorities are allowed more time to inflate the global economy. As we discuss in scenario 3, the more likely risk scenario is inflation, especially as time progresses.
Here is how DB views the various scenario probabilities:
Some other observations from DB, include:
A comparison of relative cheapness of equities vs fixed income:
A look at Shiller P/E ratios over numerous business cycles, going back all the way to 1881:
Cumulative fund flows over the past year iinto various asset classes
Earnings trends since 1988: the bubble pop is clearly evident.
And some observations on sovereign risk - as Zero Hedge has been saying for long time, and as many prominent hedge funds have been executing, buying US CDS at current levels is a no brainer.
We’ve been discussing Sovereign risk at length recently and at the front of this piece. A big event in this complex remains the biggest concern in 2010. It’s worth showing a graph of a basket of Sovereign CDS spreads with Financial Senior spreads as a comparison. We also plot Greece CDS spreads as this has been the recent topical concern in Europe.
For us the wider world of risk looks a much more attractive proposition if you can assume massive ongoing global Government intervention. With this view of the world shorting Sovereign risk as a pro-risk hedge makes some sense. The market has increasingly been convinced that the private sector risks are still being underwritten by Governments and will be for some time. With this the risks to their credit quality must surely have increased. As a long-term trade, buying protection in Sovereign CDS does have obvious problems in that you could have significant inflation and/or currency adjustments instead of defaults. However one can see why it’s a useful 'cheap-ish' hedge on the hope that someone else will want to hedge at a more expensive level further out. An outright short in Government bond markets should also be contemplated.
Lastly, observations on the "end" of the dollar carry trade:
Since early 2008, risk assets have generally moved in tandem with the Dollar with an inverse relationship. This is shown in Figure 21 which plots the Dollar (DXY Index) against the S&P 500 (used here as a barometer of risk).
What we don’t know at this stage is whether risk assets could withstand a strengthening of the Dollar that most currency strategists expect in 2010. The bulls would argue that Dollar strength would represent further normalization in markets and risk assets could de-couple from their near two-year trend. However the jury is still out and if the Dollar strengthens because of a perception that the US rate cycle is starting to turn, then it’s possible that the whole “Dollar Carry Trade” could reverse leading to investors selling risk assets regardless of the fundamentals.
Much more in the full report found here