Goldman Asks If US Slowdown Is Priced In
Dominic Wilson, Director of Global macro and market research, asks the most critical question relevant for all market participants:i.e., has the market priced in the US economic slowdown. And after meandering without much conviction on both sides of the argument, and of course invoking the Goldman trademark "decoupling" (which at least he notes is "always challenging to trade" to all except to Jim O'Neill) Wilson states: "A simple picture of the 10-year yield and the SPX would suggest that bond investors are more negative and we have some sympathy with that notion." Of course, applying the traditional dodecatuple reverse squid psychology slant to this exercise, provides little help to those seeking the answer of what to do with their meager and declining savings (or even Other People's Money).
From Dominic Wilson, "Is the US Slowdown Priced?"
1. The US slowdown remains the key dynamic and the recent data has reinforced our worries there. But with markets already moving a decent way to pricing our own more downbeat growth view, it is becoming harder to find opportunities to position for slower US growth on an absolute basis. Our relative view of the US versus the rest of the world, however, is very clearly not priced and that – alongside fresh policy responses – remains our primary focus. For risk assets, easy financial conditions are an important offset to the drumbeat of negative US data surprises, but we think the market will take its cue more from signs that the US deceleration is stabilizing. Those are not clear yet, but it is that ‘second derivative’ that we think it is important to look for again.
2. Until then, we are avoiding a strong view on direction of risk assets after an aborted attempt to short VIX futures two weeks ago. And as our latest Bond Snapshot describes, we are neutral on government bonds here with US 10-year yields already near our 3-month forecast. We have instead positioned most clearly for trades on the relative underperformance of US growth, particularly with respect to China and where we can find ‘risk-neutral’ ideas. That theme has been firmly rewarded in FX (our short MXN/CLP is close to target; and we still like AUD/CAD, where a trailing stop took us out at good gains) and in credit (where we are short consumer cyclicals against the index). In equities, the same idea has been choppier – and we closed a short in our Consumer Rotation basket a little underwater. But it is still the general idea of ‘decoupling’ that we are looking at most closely in terms of new ideas.
3. As Jan Hatzius and team have described, the US data picture is troubling. The massive pullback in housing-related data, a very weak durable goods report and a sharp drop in the Philly Fed survey have all added to the picture of a faltering final demand picture, consistent with (and perhaps even weaker) than our own forecasts. Our US Surprise Index has remained persistently negative. And while the market has not underperformed sharply on days of major US releases in August as it did in June and July, this is in part because traditionally second-tier data has been having a more pronounced negative impact. The coming week provides the usual top-tier data bonanza and our views on the major releases are generally a bit softer than consensus.
4. The big question is the extent to which our US view is priced. Consensus forecasts still have a long way to go, as Jan has showed. Blue Chip sees 2010H2 at 2.6%, down 50bp since April but well above our own 1.5% forecast and 2011 growth forecasts are still at 3% versus our own closer to 2% view. But the market appears to have made bigger adjustments. Our Wavefront baskets are consistent with a more than 100bp fall in GDP growth expectations (until end 2011) since April. That would put us at least 2/3 of the way towards pricing our own views, which implied that a roughly 150bp downgrade to US growth views was required at the time. Simple comparisons with the bond market, suggest that revisions there are at least as large and Francesco Garzarelli and team have signaled that bonds are unlikely to have much upside unless our own forecast view deteriorates further. So on an absolute basis, it is getting harder to position for softer US growth unless our own forecasts fall more.
5. But it is also hard to think that risk assets can find a very firm footing as long as clear US disappointments continue. We argued in early 2009 that markets would be reassured by signs that the worst point in growth had been reached (the so-called ‘second derivative’), even if absolute growth rates were weak. With markets worrying about ‘double-dip’ risk, signs that the deceleration in the US is ending are likely to be welcome. Taking our GDP forecasts literally the slowdown is mostly behind us. After Friday’s 1.6% Q2 GDP print, our forecast of 1.5% growth trajectory for the next three quarters is ‘more of the same’. But a broader view suggests that stabilization may be further away. We see final demand growth bottoming in Q4 and the guts of the ISM alongside the Philly Fed already point to an ISM headline below 50. On that basis, it might still be a couple of months before the market can get comfortable that growth is no longer slowing. Given the importance of this point, we are watching three areas particularly closely. The first is our GLI, where we get the August final release next Wednesday after an Advanced Reading that was a touch better than July’s. The second is jobless claims, where last week’s decline is mildly reassuring. The third is the new orders-inventories balance in the ISM, which has provided a good forward guide to the production path lately.
6. For all the gloom from the US, there are important offsets to the more negative view. First, US cyclical sectors are already depressed, as Ed McKelvey has described, and financial stresses are also much lower as our own FSI shows. This makes it harder to envisage a sharp slowdown than two years ago. Second, and obvious in both our growth and rates forecasts, is what is going on in the rest of the world, where our forecast are above consensus in many places. In terms of the key areas of market focus, Germany continues to shine as both Erik Nielsen and Jim O’Neill have pointed out, though broader European surveys are slowing a little now. And while China’s data is yet to turn decisively, we continue to expect a gradual shift away from tightening to underpin stronger growth there as the year rolls on, though continued rumblings about possible increased bank provisioning means that the policy mix may remain more nuanced.
7. Finally, the behavior of financial conditions is still a plus so far. Despite the pressure on stocks, the sharp fall in yields means that our US FCI has stayed quite easy. And our US Private Borrowing Rate has reached its lowest level on record as housing and corporate rates have dropped sharply. This matters not just as a cushion for the US. As Jim O’Neill has pointed out, tightening US financial conditions are a more critical transmission mechanism to the rest of the world than the direct impact of US growth. So if our US FCI remains easy, decoupling also becomes easier. The near-term risk here may come from the reluctance of the Fed to embrace QE2. The FCI has already tightened since the August FOMC and this week revealed that FOMC members may not be quick to embrace the need for fresh easing. Likewise, Bernanke’s Jackson Hole speech provided a firm reminder of the Fed’s arsenal, but no sense of imminent deployment. This means that the next couple of FOMC meetings may be obstacles more than springboards for the market. The good news – as Jari Stehn has shown – is that should the Fed choose to re-engage, the first round of asset purchases suggests their actions may be quite effective.
8. ‘Decoupling’ – again core to our own forecasts – is always challenging to trade. The market will inevitably worry that slower US growth will show up in slower growth elsewhere particularly as the US damage has become more visible. And it is challenging to find implementations that don’t pick up exposure to the overall cyclical or risk picture. The recent bout of USD strength and the brief underperformance of international exposures in the US equity market show that the market is apt to doubt the resilience of others when the US data looks particularly bad. But stepping back, particularly in areas that balance China-related exposure against the US (EM versus DM indices; AUD/CAD; CLP/MXN), the trend towards non-US outperformance are still very clear. We think that trend will continue, if not broaden, even if the market loses faith periodically.
9. Even after the latest moves, our rate forecasts look for wider rate spreads to the US at the end of the 2011 than the market currently prices in every one of the G10. It is also hard to imagine how that view can be right and the USD not ultimately weaken more. While the weakening in EUR/$ might appear to run counter to that theme – and to recent data – it may also reflect the re-emergence of sovereign risks. Those moves have been surprisingly large for the modest attention they have attracted, with Ireland at new highs post S&P downgrade and sharp widening in Portugal, Spain and Italy. We had steered clear of European exposures anticipating this resurfacing of European political risk and this has been the main motivation for our 1.22 EUR/$ 3-month forecast, in spite of a more positive longer-term view. In fact, simple models suggest that with sovereign spreads at these levels, EUR/$ could plausibly trade lower even with the better relative growth news.
10. FX has been interesting in other majors, where two of our more controversial short-term forecasts (for a lower USD/JPY and substantial new lows in EUR/CHF) have been playing out. In both cases policy risk is rising as a result. For Switzerland, safe haven flows has driven the TWI to new highs. As Dirk Schumacher has described, the SNB is in the tricky position of weighing up further intervention at a time when the zero rate policy looks inappropriate for much of the economy. Japan’s challenge has been even simpler, as Robin Brooks and Fiona Lake have described. The JPY is trading very rich to fair value. But with policy rates identical to the US but a much lower inflation rate, real rates are significantly higher in Japan. Alongside the BOJ’s reluctance to ease aggressively through the balance sheet, this is leaving Japan ‘trapped’ with an inappropriately strong FX rate. Government rhetoric has increased sharply – and could increase further if Ozawa takes the helm – but the emergency BOJ meeting overnight provided only modest action. Without broader BOJ easing measures, it is unclear how sustained the impact of intervention would be, though it would certainly signal some shift. Given both US and Japanese concerns, we are also likely to see more pressure for CNY appreciation, a dynamic for which we remain positioned.
11. Finally, is there a bond-equity disconnect? A simple picture of the 10-year yield and the SPX would suggest that bond investors are more negative and we have some sympathy with that notion. But neither asset is a straightforward reflection of market growth views and there can be good reasons why these gaps open up. If the market expects policy easing to offset growth pressure successfully bonds and equities will behave differently than if the market is simply downgrading growth. The yield curve gives clues as to which is underway and the 10s-5s slope has behaved much less ‘inconsistently’ versus equities than yield levels. Both show the market swinging from optimism about Fed easing in July (yields lower but on a steeper curve, stocks up) to growth fear in August (yields lower but flattening curve, stocks down). Stocks and bonds are also sensitive to different growth conditions. Equities are most likely to see pressure when growth is decelerating, but bond yields may drift lower as long as growth remains below trend. In that respect, the US continues to track along a fairly typical path for a post-bust recovery. As we have shown before that has usually involved a very slow return to trend growth and fresh lows in interest rates for several years even long after stocks are past their weakest point.