Goldman Sachs On How To Navigate The Slowdown
Remember when a week ago the world was slowing down? Apparently all it takes to forget reality is for Europe to sweep the fact that its banks are insolvent under the rug courtesy of a systematic farce conducted by the very system the banks are part of, rendered even more "credible" since as of today it appears no banks will fail the stress test. On the US earnings front, a materials company beating reduced expectations and a chip maker having just record the best quarter in its history (what growth next for Intel: 80% margins? 90%? every household in China buying an i7 980 for their 7th toaster in their 5th house?), even as global trade is paradoxically stalling following an all time record month for Chinese trade? Americans may be unemployed and homeless but they sure like their iPads and their fast PCs. Either way, to remind readers that despite the latest market run up on no actual positive economic data, here is Dominic Wilson, Director of Global Macro & Markets Research at Goldman, with advice to clients on how to navigate the "slowdown."
Global Market Views: Navigating the Slowdown
1. Over the last few weeks, it has become clearer that the US economy has been slowing. It is this theme that has dominated markets lately, not earlier European sovereign fears. We have long had a view that 2010H2 would show significantly softer US growth. But for early in the year, US data generally proved better than expected and markets traded along those lines. As a result, we have been slower to reposition for this shift than we would have liked even as the market has moved closer to our own long-standing views. We think that there is still room to position for slower US growth. But with systemic risks overpriced, already-high levels of concern about Europe and China and a solid earnings season ahead we are currently doing so more on a relative than an absolute basis.
2. For all the legitimate focus on the European sovereign story, the broad macro backdrop to the last two months of market pressure in hindsight looks simpler. The last two months has delivered fairly consistent disappointments in the US data from housing to payrolls to the ISM surveys. Global PMIs peaked in April. Our new improved GLI (we revamped it a few weeks ago, a process we carry out roughly every 4 years) now shows a clearer peak in March of this year (having bottomed in February 2009) and moderation since then. Global data remains consistent with robust current growth. But disappointments are disappointments. Against that backdrop, markets have until recently done what they often do when faced with this kind of news, until recently pushing equities (cyclicals in particular) lower, hurting commodities and related currencies and pushing bond yields up.
3. In relative terms, the market has also indicated that a shift in its worries from European sovereign risk towards US slowing began some time ago. US bonds have outperformed and the spread between Eurozone and US 2-year yields is back to January levels, having round-tripped a 50bp move; the SPX has been a laggard to both European and EM equities lately (even in USD); US consumer and housing-related areas have led the way down, with our Wavefront Housing and Consumer Growth baskets giving back the year’s gains; and even against the EUR, the USD has lost decent ground. In most cases, this represents a significant reversal from December to April when positive US surprises (absolute and relative) drove many markets.
4. The shift in focus to a US slowdown – and the argument that deflation not inflation is the major risk for the G3 – should not be surprising and has been a core part of our 2010 outlook. From a trading perspective, the problem has been that for several months, US news was continually ahead of expectations, a dynamic that was arguably the key market theme between December and April (and one we traded). But the basic problems that our US forecast has always flagged – and which are largely unconnected to sovereign fears – have become more visible. We still expect final demand to grow at just 1.5% in the second half as the inventory boost fades and fiscal policy becomes a drag. At the same time, the policy debate has shifted in ways that make a rapid response less likely. Jan Hatzius and team have been beating the drum louder about our 2010 views and the growing risks to 2011 in a number of important pieces over the last few weeks.
5. In the very near-term, there are some important offsets to this backdrop. First, sentiment shifted sharply negative and expectations have clearly fallen. Deflation risk (something we had to consciously raise for most of the last 12 months given our long bond bias) is now routinely on the agenda. So the near-term hurdle on the macro news is lower and we have seen some reversion in the data recently. Second, US earnings season is kicking off. Current earnings should be reassuring, so guidance will be in focus. But the market is heading into the season with more fear than has been true for several quarters. Third, there are signs that Q2 GDP growth is coming in stronger than expected in several places. Globally, things are slowing, but as Kevin Daly and Alex Kelston have showed, deceleration is coming from what look like stronger levels of Q2 growth than many expected. So here too the market may have to process better current news even as it worries about the forward path.
6. But although markets have moved quickly to price a weaker view, on our forecasts, US growth expectations are likely to have to fall further probably on an absolute basis, and certainly relative to many other places. How best to trade that view from here, however, depends not just on how sharp the US deceleration proves to be but also on how two other risks shift. As we addressed in 2006 during the great ‘decoupling’ debate, the first is whether the rest of the world slows more or less than expected. The second is whether systemic/sovereign risks will grow or recede. In practice, many assets that have exposure to US growth risk also have exposure to these two issues and it is important to weigh all three. If growth disappointments are broad and systemic risk increases, the impact on assets is obvious (short equities, short cyclicals, short commodities, long bonds). But if the rest of the world holds up relatively better, or systemic risks ease, more focused implementations will do better. In general, a relative focus on domestic-exposed equities, front end rather than long-end trades (not an easily available option currently) and USD shorts would often be better alternatives.
7. While the market may not have fully adjusted to our own US view, our views of the non-US growth picture have been less negative and the non-US data picture less uniformly disappointing. Recent decisions to hike in a range of economies (New Zealand, Sweden, Canada, Peru, Chile, India, Korea) suggest greater comfort with the growth picture in places. In Europe, we continue to forecast better than expected growth. While Q2 is shaping up well after a disappointing Q1, it is really Q3 that will be decisive. Europe’s PMIs are not slowing rapidly, though parts of consumer confidence look soft. And while our new China forecasts show sharper sequential slowing in the near-term than consensus, and PMIs are falling, we see a shift away from policy tightening and an improved growth picture further out (more on this below). Confusingly, some of the latest Asian export data would point to better US growth but less in Europe and China.
8. Sovereign and systemic risks may also recede further, at least in the near-term, as we have argued both on the sovereign front (see Francesco Garzarelli and team’s Bond Snapshot) and in credit (in recent Credit Lines from Charlie Himmelberg and team). The European stress tests – due on July 23rd – look broader than initially envisaged, reaching deeper into the Cajas and Landesbanken and stressing for sovereign losses. Inevitably, arguments that they are still insufficient (particularly with respect to the rumoured haircuts on public debt) are in full swing. But just a few weeks ago, it was common to hear complaints that a) Germany would never publish; b) sovereigns would not be stressed at all; c) only the very largest institutions would be covered. There is clearly still plenty of risk, particularly since the path to the kind of substantial capital-raising that bookended the US test is less clear. But overall, things are turning out better than expected lately.
9. Our views with respect to the three major risk exposures are thus as follows; a bias towards short US growth exposure; a bias to be long sovereign/systemic risk exposures; lower conviction on non-US growth – particularly with respect to timing – but our forecasts lean positive. Broad directional views on equity indices and long-dated bond markets do not fall cleanly from this set of views. Equity indices have exposure to further US growth downside but further relaxation about elevated systemic risk would help. Long-dated bonds have rallied sharply already and while they have exposure to further US slowing, they are vulnerable to better non-US growth and to reversal of the flight to quality premium that relaxation about systemic risk could bring, as our Sudoku framework highlights. We cut our main directional trades (long DAX, short USD/MXN) and our only trade on US bonds is for them to stay range-bound (expressed through a “strangle”).
10. Two kinds of trades may reflect these views better. The first is long exposure to systemic or sovereign risk worries in forms that have some protection against growth risk. Our Credit Strategy team is long High Yield CDX against shorts in a basket of CCC-rated credits; last Friday, we went long Spanish 5-year bonds against shorts in Germany, activating a more constructive view on Spain flagged in late June; and we remain short protection in a basket of ‘elevated’ CDS (Korea, China, Hungary, Czech). The second is relative exposures to the US growth slowdown. Noah Weisberger and team have gone short our Wavefront Consumer Rotation basket (short consumer cyclicals against other cyclicals) and flagged similar trades (long China-related or foreign cyclicals against domestic cyclicals). And in FX, our fresh long in AUD/CAD has some of this flavour (long China, short US growth), though it is vulnerable to better recent Canadian news.
11. The toughest issue is how much to rely on better than expected growth outside the US. If both the US and non-US growth disappoint, a negative outright stance would be logical. If non-US growth holds up close to our forecasts, two trends where we have less exposure might extend. The first is USD weakness (something we are weighing up a lot currently) alongside a further shift back towards pricing hikes in non-US economies (pricing of Australian rate cuts recently was a major overshoot). The second is EM equity outperformance, a trend we anticipated in a Global Weekly in late March, but a little too early. For many large EM markets – which have been tightening – some slowing in US growth might actually ease the policy dilemma. Since tightening risk has weighed on EM markets, this in turn might help the EM/DM outperformance to continue.
12. In all this, China looms large, given the way its cycle has run ahead of others. Beijing has no doubt noticed the signs of slowing we all see. A shift towards more supportive policy – and there have been hints – could be a meaningful positive, both for regional equities and regional FX. We are watching closely for clues that this is underway. The CNY has also dropped off the radar already – a symptom of our collective attention deficit disorder. After a nearly 1pct move in the last 2-3 weeks, it looks odd to be pricing just 0.5pct more in the next 6 months. The Chinese resisted CNY depreciation both in the Asian crisis in 1997-98 and the global crisis in 2008 (the largest 6-month fall in CNY in the last decade is 0.5% amid a global collapse that pushed their TWI sharply higher). The notion that this may be about to change, when they are signaling the opposite, is implausible. If USD depreciation continues it will become even less likely. Thomas Stolper and team took us long the 12-month forward before the shift and still like the view. We have also added a short USD/SGD position ahead of tonight’s GDP print, supported by many of the forces described here.