The Equity 'Air-Pocket' And 5 Reasons To Worry

Tyler Durden's picture

While risk-on has been a successful strategy since September, UBS' Stephane Deo is growing more cautious. The positives of activity improvement, reduction of political risks, and positioning are now considerably less convincing, and Deo is worried about a potential 'pocket of air' in the market in the near future. They lay out five reasons to be concerned from sentiment and valuation to political concerns in the US and Europe along with fundamental macro deterioration.


Via UBS' Stephane Deo,

Reason #1: US debt ceiling

One of our main worries is complacency over the US debt ceiling debate. We think this could prove much more difficult and damaging than many think. Our conversations with investors lead us to think that the market has adopted a very sanguine approach; by sharp contrast, what we hear from UBS' Office of Public Policy in Washington seems to point to much more troublesome issues. There are a number of signposts to keep in mind, the following table summarises the key ones.

Can things get resolved before the March 27th deadline? It is difficult to make this the central case scenario. In March we face the prospect of difficult negotiations and lots of partisan noise from the Hill. Ultimately we believe that a temporary government shut-down at the end of March should be regarded as the central case scenario. We believe that the negotiations to replace the sequester will eventually lead to a package close to but below $1 trillion, while the initial plan is a cut of $1.2 trillion. This is likely to include some partial reversal of the 2013 sequestration. We do not believe substantial sources of new taxes will be included given dissent on substance and process within Democratic ranks and strong opposition to tax increases among Republicans (although increased revenue through closing small tax loopholes is possible).

In terms of timing, if the above scenario indeed unfolds, the climax of the crisis is likely to come in mid-to-end July when the debt ceiling can’t be postponed further. From a market point of view, this means that the noise from Washington is likely to mount in Q2, but if one thinks about a “July-2011” moment, this is more likely to come later, during the summer. A reduction of risk in the portfolio such as the one we propose below, hence plays to some extent on the market’s expectations as the most rancorous parts of the negotiation are still a few months away.

Instead of being solved as described above, Congress and the Administration might not reach an agreement. In the no-agreement scenario after a raucous debate and government shut-down the debt ceiling would again be extended for a short period of time. This would avoid a major crisis and gridlock, but it would mean uncertainty on the timing and results of the negotiation. It would also keep the market on their toes. How long could this scenario last? Partisan deadlock could be protracted; however we believe that the funding difficulties of the government would reach a climax in the middle of the summer when the administration would have exhausted “exceptional measures” to fund the expenses. At this point, as in 1995, questions about a potential default would become pressing and certainly an agreement would be forced. But this, again, can be postponed with a suspension of the debt ceiling. In truth, it is very difficult to identify a true deadline in the process.

During the process, there could be talk about the US defaulting on their debt. We think this is a very remote possibility and we would attach a negligible probability to a default. The sequestration is not a source of concern on that front. It would cut spending, hence have no impact on the government’s ability to service the debt; arguably it would even raise the ability of the government to service the debt as some expenses would disappear. The risk stems from the debt ceiling: when reached, the funding of the government would come exclusively from tax receipts. The government could only borrow at the rate that bonds mature. Because debt service is one of the top priorities it is difficult to imagine a situation in which tax receipts would not be sufficient to cover debt repayments. If such an unlikely situation were to occur it is even unclear if US default would be possible. Indeed article XIV-4 of the constitution says that “The validity of the public debt of the United States, authorized by law, [..], shall not be questioned.” Hence the means to service debt could be provided. In summary, talks about a US default can certainly become fashionable, rating agencies might also take the opportunity to downgrade the US again, but in truth we think that even a technical default is extremely unlikely.

The first channel is simply economic growth. The sequestration, if fully implemented is expected by UBS US Chief Economist Maury Harris to impact GDP by 0.4%. Arguably this would not be such a sizeable impact: the current US growth forecast for 2013 stands at 2.3% while the latest consensus is at 2.0%: the potential impact of the sequestration would thus be (give or take a decimal point) the gap between our forecast and the Street’s. This is however a bit simplistic. The time-lag of the impact means that most of the effect will be felt later, falling mostly in 2014. Because 2014 is an election year, we very much doubt that Congress would be willing to inflict too much damage on the economy and that Congress will be strongly motivated to remove part of the sequester. Finally, let’s not forget that the Fed is still doing QE at full speed. We expect the QE programme to be reduced during the second half of the year, but that forecast is based on the view that the economy is growing close to 3% in H2 this year. If the fiscal tightening proves damaging, Fed QE is likely to last longer, at least partly compensating the fiscal drag.

In short, we do not see the sequester as a material source of concern. It could hurt our forecast at the margin, but certainly would not substantially change our view.

The second channel would be via volatility. Historical precedents are quite telling. In the chart below we simply take the VIX as an illustration. The previous two peaks in volatility were registered on August 8th 2011 and on December 30th 2012. The first one is just after the downgrade of the US in the wake of the debt ceiling negotiation. The elevated level of VIX at the time was also partly to be blamed on Europe, as Italy was put under pressure during the summer of 2011. The second peak is the latest fiscal cliff negotiation at the end of last year.

The third and last channel would be via portfolio allocation. This is very much linked to the previous argument: a surge in volatility would trigger a risk-off move like it did in August 2011. We however note that the fiscal cliff negotiations at the end of last year did not prompt such a move.

Conclusion: as the deadline (or we should say the deadlines) approaches, we are becoming uncomfortable with our risk-on position. This has worked very well indeed recently, but there is an increasing rationale for neutralising our position and removing part of the risk from our portfolio. After the almost uninterrupted equity rally we have enjoyed since mid-June, valuations are not as compelling any more and a technical pull-back is a distinct possibility.

Reason #2: end of QE

The UBS economic team took the view a while ago that QE could be reduced during the second half of the year. This is based on the view that the economy will be growing at close to 3% during the second half of the year with the labour market continuing to create jobs on a steady base.

Last week’s FOMC minutes surprised the market showing that the Fed is divided between those who would like to reduce the current balance sheet expansion, and those who would like to continue QE at the current pace: “…many participants also expressed some concerns about potential costs andrisks arising from further asset purchases.”

We also note that even once-dovish Fed members like Bullard have been talking about the exit strategy. This means that the balance of power is gradually shifting and a continuation of reasonable growth with job creation above 150k a month should continue to tilt the FOMC towards considering a reduction of QE in H2 this year.

Apart from the obvious direct impact on FI products, we identified essentially two asset classes that are impacted by QE: EM equity and commodities. We do not believe that QE has had a large market impact this time around, for more on this topic please refer to our publications last summer.

Reason #3: some European risks

While we thought a number of political risks were receding or disappearing at the turn of the year, the Italian elections came as a wake up call: political risks are now back on the agenda in Europe. Essentially there are three main countries that could provide short-term risk.

  • Italy: this week’s elections have created an upper house that will be very difficult to govern. The market reacted predictably on the news with Italian spreads widening, stock markets plunging, EUR sliding and volatility spiking. On a fundamental note we are not that worried: Italy has the largest primary surplus of OECD countries, a deficit low enough this year to stabilise the debt to GDP and no issue with the current account. In short this is not a repeat of Q2 last year when markets plunged on the back of the Greek elections, the Italian situation is considerably different on the economic front. However this leaves us with considerable uncertainty, a country unlikely to make further progress in terms of reforms, and many reasons to worry about yet another surge in political turmoil in Europe. In short we are more worried about sentiment than fundamentals, but that is more than enough to roil markets.
  • Spain: UBS FI strategists think Spain needs to issue €135 billion this year vs. c€80 billion last year (note that this is based on a 6% deficit, the government is currently targeting €121bn, based on a 4.5% deficit). This seems very difficult to achieve without external help. So far Spain has been able to tap the market and is in advance of its funding programme, and surprisingly to us, this has been mainly on the back of foreign buying. We also note that a number of local authorities are very advanced in their funding programme. All this seems positive. We still believe however that the economic situation is challenging despite some noticeable improvements (see two charts below for example) and we think that Spain will be forced at some point to request external help, i.e. call for OMT. Calling the OMT is unlikely to be pre-emptive, it will come via a crisis with markets compelling Spain to ask for help. The spark could come from further downgrade, which would push Spain into junk, and force some investors to exit their positions as Spain falls out of benchmarks. However, as soon as the OMT is put in place markets should calm down. We do not think this will trigger a long-lasting crisis like the one we saw during the second half of 2011.
  • Cyprus: Here again the fundamentals are not worrying, simply because the numbers involved are minuscule compared to Euro zone aggregates. Cyprus however could be yet another important source of risk. First because the negotiations with the Troika could once again be difficult and long-lasting, exposing the lack of leadership in Europe. Second, because the solution might include some bailing of debt bank holders or some restructuring of the public debt. Here again the real impact on the financial sector would be negligible, but this would open again the Pandora’s box of discussions about country default; the risk is if the market extrapolates the Cyprus example to other countries.

In short, there are plenty of reasons to believe that Europe will once again provide negative news flow in the near future and cause market volatility.

In short Europe will certainly provide further sources of volatility and market unrest, but we think the potential of Europe to generate global systemic risks has declined considerably.

Reason #4: economic activity is less convincing

There has been no significant change in the UBS economic team’s forecasts since the beginning of the year. We still expect the world economy to grow at 3.0% this year and 3.4% next, which is very close to trend. What has changed though is the news flow and the momentum. The chart below shows our global growth surprise index: it increased rapidly in October, continued to progress albeit more slowly in November and December, but has been very slow so far this year.

Part of our call was based on the idea that the economy was accelerating. Data are still consistent with this idea, although the reservoir for positive surprises seems to be exhausted to a large extent.

Reason #5: sentiment and valuation

Our equity strategists have flagged warning signals from their bull/bear and relative strength indicators.

There is little information to be gathered from equity valuations. The following chart shows that the world P/E is somewhat cheap, but this is just 0.34 standard deviations away from the long-term average. We would argue that there is no compelling valuation argument one way or another.

Similarly from a regional perspective there are no particularly compelling valuations. For example the US is trading on 15.3 times, which is just below its long-term P/E average of 16.7 (note that this is the average of the MSCI USA index since 1970, one might question if that is really “long-term”, another source of data gives us an average P/E of 17.3 since 1990). This is indeed about 1/4 standard deviation away from the long-term average, providing no compelling signal.

Relative to the US, Europe is also close to its long-term P/E average. Europe traditionally trades at a discount; we find that, on average over the past 10 years, the discount was 1.9 times, it is now 1.8. Hence regional valuations are not particularly helpful at the moment in terms of providing decisive view. In short, we believe market valuations do not provide a trading signal because they are too close to what we could consider as being “fair”. There is no clear evidence that markets are cheap, nor is there evidence that markets are expensive.

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JustObserving's picture

Who in their right mind pays any attention to CBO forecasts?  By their own admission, CBO was wrong by $11.7 trillion from 2002-2011;

In January 2001, CBO's baseline projections showed a cumulative surplus of $5.6 trillion for the 2002–2011 period. The actual results have differed from those projections because of subsequent policy changes, economic developments that differed from CBO's forecast, and other factors. As a result, the federal government ran deficits from 2002 through 2011. The cumulative deficit over the 10-year period amounted to $6.1 trillion—a swing of $11.7 trillion from the January 2001 projections.

DeadFred's picture

One has to wonder what they were smoking when they projected that the current parabolic rise in debt to GDP suddenly and magically levels out starting today. I guess I missed some important announcement or something. LOL

lasvegaspersona's picture

there could be talk about the US defaulting on their debt

ha ha ha 

why default (officially) when one can default via inflation and never have to say a single word?

the 'plan' as I understand comes from Kyle Bass...let the dollar go....que sera sera. I think we will see a reset before the whole thing is allowed to unwind but that is speculative and would require some undertanding of the problem by a critical mass in DC so I'm probably just as far off as a guy saying "there could be talk about the US defaulting on their debt"...we shall soon see.

Go Tribe's picture

Yeah it's a busllshit market, but it's too cautious to crash.

TruthInSunshine's picture


These equity "markets" are more artificially pumped up than they were in 1999+2007 combined. We've got DOZENS of trillions of fiat units literally created from thin air by various central banks & distributed to backstopped masters of these same central banks (that hold taxpayers hostage) all over the world flowing directly and indirectly into equity markets AGAINST THE BACKDROP OF AN ERODING ACTUAL, FUNDAMENTAL ECONOMY.

"Pocket of air" as the author of this article suggests should be instead called a vertical tower of helium high enough to pierce earth's orbit.

When this bitch crashes, Nikkei style, every economist and anal-cyst that is trotted out before Kabuki Senate Panels, on cnBSc, Bloomturd, or that writes an op-ed for the New York Slimes or Fraud Street Journal is going to proclaim their shock and amazement at what "took place" (as if it wasn't staring them and everyone else with a pulse straight into their eyes FOR YEARS) with a conclusory, revelatory "nooone could've seen it coming!"

Stock certificates in CRM & PCLN! Get them while they're hot!

resurger's picture

Some perma bulls forcasted S&P @ 3,000 by 2016 .lol

francis_sawyer's picture

Altucher ~ It's what's for dinner...

fomcy's picture

" QE could be reduced during the second half of the year. This is based on the view that the economy will be growing at close to 3% during the second half of the year with the labor market continuing to create jobs on a steady base."

3% GDP growth where? On Mars? They should be lucky to get 1.5% Growth at most and even that is the very optimistic target, mostly artificial,

due to enormous money printing. FED: "We don't need GOLD, we need DEBT!". Looks like they are going all in.. Good luck, f*ckers!

ParkAveFlasher's picture

Chart 13: Fishy oily leakage from the collective lower intestine, barrels per day:  parabolic.

Motorhead's picture

Now those are some charts, bitchez!

czarangelus's picture

A "pocket of air?" Like a bubble?

Atomizer's picture

There is no need to worry. The TPTB can no longer afford to be the sponsorship of slave labor expansion.


End of the Capitalist World-Economy : global financial crisis 

The plans will halt once everyone is brought up to speed. :)

earleflorida's picture

'markets are cheap, markets are expensive?'

the great depression wiped out the ordinary investor for forty-five years! it wasn't until several generations later that their offspring began to tip-toe back into equitities, et.el.!

the great resession is all but a bonafide`de?pression highly sedated on prozac, and administered by the neo-thought police known today as the 'MSM'!

there is no capitalism, period! the doves decidedly turning hawkish is nothing more than a extrapolated and ficticious panacea... a placebo to temper the psyche of a myrmidon sheepleolation. what the much maligned nascent sequestration has provided for the oligarchy, is a 'two birds with one stone' reality. why? with thousands of furloughed federal workers added to the unemployment numbers will bring us back above 9%, which undoubtedly sad?, too high un`unfortunately for a duel-mandated federal reserve to halt Qe to infinity.


nice read, thankyou

flyingpigg's picture

 I can see 85 billion new printed fiat currency reasons to be worried for my short position this month... 

disabledvet's picture

"and he died in Washington DC." that would be Mr. "4 cent an acre" McComb. "as so it is with this real estate speculation as well." Alexander of course could lay claim to the title (literally and figuratively unlike the current crop) of "i used to own that State." (meaning New York State.) Damn near the whole thing with 4 million acres. that's FAR bigger than the current Adirondack Park "in which the Park now resides" ("bigger than the State of Vermont") and goes to show "just how far you can take a real estate speculation." Clearly this last one which was collapsed in 2008 "to make way for a new intergalactic super highway" dwarfs even that one. still..."no one will ever take claim in the USA to a property like Alexander McComb." (i've heard some the German "easements" in East Prussia are even more massive. And of course in Russia itself....) i find it interesting that while he was a loyalist sympathizer his son would command the US Army for a couple of decades. how's that for being a General as well...

carlsbro's picture

I love that  blended ZH arrows

ekm's picture

Let me ask a question:

A lottery ticket is $1. Almost Everybody buys 1 or more.


If a lottery ticket were $15k per piece would people buy them? The answer is no. Casinos would go out of business.


That's what S&P is right now, a lottery ticket priced at $15k. Casinos like UBS are going out of business. NYSE already bankrupted and CME is looking for a buyer but deutsche boerse declined.


The only way for casinos to survive would be to let S&P collapse to 400 or less, so the lottery tickets (stocks) become again affordable to buy and casinos (banks and brokerages) stay in the business of trading lottery tickets.



ekm's picture


Few casinos (primary dealers) would have to be the sacrificial lambs for the rest of them to survive. We had Lehman, Bear stearns, MFG as sacrificial lambs. Obviously it was not enough.

I'm expecting Deutsche Securities and RBS Securities to disappear in an attempt to save the others.


Atomizer's picture

This process has been systematically planned over 30+ years ago. Sustainably was a $1 dollar bet. Do you understand now?  

ekm's picture

It can't continue any longer since at S&P 1500, there's nothing left to buy or sell in the world.


Stocks are all owned by primary dealers-cb-gov. CB owns most of bonds. Commodities are all owned and stored by primary dealers-cb-gov.


The plan is over. They have to go back to square one (s&P at 150 or so) to start another 30 year casino.

Atomizer's picture

Just relax, raise your chin. After all the drama & MSM doom, we will begin to set course for a better investment future. Patience is a virtue.

ebworthen's picture

"Disagreement" at the FED is a smokescreen.

QE to the moon, and back, and back again.

Of course, if enough retail money goes into equities, and they jigger unemployment down to 6.5% using "Jedi mind-meld" tricks, they may just stop QE immediately and raise rates to crash the markets, pop the current housing and student loan bubbles, and bail out Wall Street all over again.

P/E for stocks is meaningless in this $6+ Trillion of FED jizz to prop these "markets".

If you think employment is going to improve, and that tax revenues aren't going to suffer an epic collapse (revolt) over Obamacare I suggest you think it through.

The U.S.S.A. has crossed the Rubicon: the debt will never be paid, GDP will never return to post WWII levels, and WWIII will be the end result of these Keynesian fantasies devoid of the rule-of-law.

ekm's picture

QE has a limit. When the money thrown into the world buys up everything, then the economy contracts which is right now.


QE is done, IMO until few trillions are destroyed by sacrificing 2 or 3 primary dealers.

No more need for new money since everything has been purchased and owned/stored already.


The beauty of open ended QE is that can be shutoff at any time.

I think it's over for QE.

mind_imminst's picture

I doubt it ekm. All central bankers of the world now have free license to print literally to infinity. Politicians and most of the public is convinced that QE is a magic bullet that saves the world and  creates wealth. If the stock market drops a few percent, the FED will just print 2x, 3x, 4x, until stocks (nominally) rise again.

ekm's picture

Printing means buying.

What's left to buy?

TruthInSunshine's picture

So many intelligent people miss the "follow the money" memo:  The ones controlling fiat fractional central banks can't make their expected returns without more frequent market "disruptions" and "crises" of larger proportions; in fact, they can't even survive without such increasingly frequent and larger-in-scale boom & bust scenarios.

They can't make returns from transaction volume nor from the past model of financing in the present ZIRP/NIRP that would allow them to be profitable (that yields an amount that can't even get them into sustainable profit territory in this New World)-- they have to load the dice, force snake eyes, and then scoop up the pile of chips in order to make bank.

The traditional role of finance as both a means of lubricating the gears of commerce and a means of reaping respectable & sufficient levels of profit for the lender from a historical perspective is dead and buried.

The new role requires Harvest via a new crisis every several years.


Tombstone's picture

Debt will be inflated away by QE, which will not end for at least another 10 years, since there is no other choice to get rid of it.  Europe will not crater because Benny is pumping $billlions into it; he cannot afford to let Europe and his Kommunist brethern fall.  The world economy is back because China, the kingpin of Kommunist governments, will dictate rising GDP and trade.  Mainstream valuations put stocks at a PE of 14-15 (true PE is likely 50% higher, but who cares) so there is much room to run.   As long as the glue doesn't melt, this house of cards will support more levels.  S&P will go to 1,900-2,000 over next 18 months.  The welfare state is alive and well and besides, we still have debt capacity to support the whole shebang.  When gold is moving $100-150/day and ratcheting toward $10,000, that will be the time to head for the hills.  Major triple tops (S&P chart) are very rare; not that there won't be days to bury your head in the sand.

fonzannoon's picture

if one can inflate debt away then why is the debt still climbing while we are going for 85 bil a month. at what point does the debt start dropping because our made up funny money starts paying down the debt?

All Risk No Reward's picture

Issuing more debt can't "inflate the debt away" by definition.

That's as absurd as believing one can pay off their credit cards by taking out cash advances with on their credit cards.

The mistake most people make is assuming the government is sovereign to the government.

It is not - and it is trivial to prove.

A sovereign nation would NEVER allow a private cartel to define and issue its money supply, BY DEFINITION!

A new incarnation of the same system that slayed Napoleon is literally waging war against America and the world - and they are using inextinguishable debt to seize control of governments and will use government to strike down liberties and control populations via the police state THE FEDERAL RESERVE IS FUNDING.

Believe it when I say the Fed isn't funding the police state because it can overthrow their interests.  The police state will enforce their interests.

The key is to understand their interests.

They own trillions in debt paper.

They own trillions in money.

They owe trillions in debt.

They are giving 3% 30 year loans.

Their interests appear to be:

1. Offload their debt to the public - check

2. Increase their cash position with the debt position going to society - check

3. Continue bilding the police state - check

4. Conditioning society to the TBTF&Jail meme - check

There interest doesn't include allow their trillions to be converted to nothingness and they will not do so while they hold all that cash and paper.  They need to transform that debt paper and cash into physical reality BEFORE they hyperinflate to balance their books.

That's always been the plan - as is deceiving the general public about the plan.

orangegeek's picture

Debt ceiling?  Code for "let's have a fkg meeting so we can make the number bigger".  It floors me how both sides work together and keep pushing it higher.


Big fat fkg government.

css1971's picture

Averages remove information and often distort the truth.

The American market is overpriced, the major european markets are overpriced. You don't have to invest in those, there is a big wide world out thee where there are markets which are underpriced.


Catullus's picture

Or the Fed can buy the short end of the curve, hold the bonds to maturity, and effectively fund the treasury. As the debt expires, treasury pays the Fed, who remits the payments back to the Treasury as "profits".

Getting oh so close to just creating a ledger entry for the US Government to fund itself ad infintium.


The no maturity bond issuance. Make up the accounting on this. Give the treasury $1trillion, they'll pay you an "acceptable" interest rate forever.

Edward Fiatski's picture

Hey, a budget SUPRLUS in 1998-2001? Can't have that - THERMITE'D, bitchez.

Gold N Glocks's picture

Real Americans don't negoitiate with Kenyans.

sbenard's picture

"Air pocket" is just another word for a bubble.

More "air pockets" courtesy of Bubbles Bernanke!

They Tried to Steal My Gold's picture

The PE ratio is neither cheap nor expensive a perfect excuse for fund managers t ocontinue pushing the paper....


UNTIL the E gets cut in half and becomes a c......


Anybody on this board think they are going to spend more for 2013?

Stuck on Zero's picture

Great work.  The problem I have with the debt to GDP ratio chart. Is that the debt number is fictitious and the GDP number is fictitious.  Debt should include entitlements and the GDP is 50% too high because of financial trades.