The much anticipated Goldman Sachs list of "Top Trades Recommendations for 2012" is out... And the squid is bearish. Which is bad news, as if there is one thing one does not want is to be aligned with Goldman's salesforce. Let's dig in.
In a nutshell:
And in detail:
Our First 2012 Top Trades Focus on European Cyclical Risk, Policy Asymmetries and Commodity Constraints
Given the acute economic and financial market uncertainties as we launch our 2012 Top Trade recommendations, we have focused on areas where our near-term confidence is high and where there are important asymmetries or possibilities of being rewarded in multiple states of the world. By the same token, we are likely to re-evaluate them more frequently than in previous years as the balance between market pressure and policy reaction changes.
The first theme is further near-term economic and financial deterioration in the Euro area. Market pressure is likely to be the key mechanism through which the crisis itself intensifies and a policy response is forced. So it makes sense to position for downside here. The risk is that, outside of disorderly ‘tail scenarios’ where it is easy to envisage significantly more market damage, markets are already priced for quite bad outcomes in most places. So in choosing our trades, we have tried to avoid areas that are more direct reflections of the overall Euro area risk premium (such as the currency and peripheral spreads), and instead have focused relatively more on cyclical exposures, given the economic damage that has already been set in train. The recommendation to be short an index of European high yield credits (Xover index) should benefit from the fact that tightening credit conditions and a contracting economy are likely to hurt high yield borrowers disproportionately hard.
The second theme is the possibility of more radical policy responses. We expect QE3 in the US, additional Gilt purchases in the UK and a reasonable chance of further Swiss intervention. The recommendation to be long EUR/CHF benefits from the asymmetry caused by the peg, with both a much better European scenario and a much worse one (that includes a slowing Swiss economy) likely to push the cross higher through a re-peg. The short German Bund trade also has some of this flavour, with the trade potentially benefiting both from a move towards ‘debt mutualisation’ in the Euro area or a less orderly outcome that forces the German government to support its financial sector.
The third theme relates to the relative resilience of parts of the EM world and the commodity constraints that are a continued focus. The long Brent recommendation is a direct expression of that supply-constrained situation in the oil market, but long Canadian equities versus Japanese equities is also an oil exporter versus cyclical importer expression in equities.
The long CNY and MYR versus GBP and USD combines aspects of the last two themes, being long countries with current account surpluses and relatively resilient economics, versus current account deficit countries that are increasingly likely to use aggressive QE policies in order to exert downward pressure on their respective currencies.
Overall these trades strike a balance between our cautious view on Euro-area developments, on the one hand, while remaining more open-minded on the possibility of transmission more broadly.
1. Short European High Yield credit (Buying protection on the iTraxx Crossover index), for a target of 950bp (opened at 770bp) and a potential return of 4.5%, stop at 680bp
We recommend going short the high yield corporate bond market in Europe by selling protection on the iTraxx Xover index. We expect this trade to benefit from the following considerations.
- The credit quality of European non-financial firms has not recovered to its pre-crisis level (see “European credit fundamentals: not so good,” The Credit Line, November 7, 2011). The credit quality of US firms, by contrast, is at its highest level in 25 years. Thus a recession in Europe—our forecast—could put considerable pressure on European high yield firms in 2012. We see mostly downside risk to this growth forecast, with very little upside.
- Tightening credit conditions in Europe—with meaningful risk of a very sharp tightening—are likely to fall disproportionately harder on high-yield borrowers. European companies in general rely much more on bank loans than bond debt in their capital structures (by a ratio of roughly 4-to-1, according to our estimates). Thus, we think companies in Europe are more exposed to a contraction in bank balance sheets in 2012 than US companies were in 2008. We suspect that such pressures on bank balance sheets have already caused a meaningful credit tightening, and we think this pressure is likely to escalate as growth slows and the sovereign crisis persists.
- Owing to the enormous pressures on fiscal budgets, financially distressed companies in the private sector are much less likely to receive sovereign assistance today than they were in the past. The benefits from such implicit sovereign support are difficult to quantify empirically, but we have long thought that bondholders in European companies have taken a degree of comfort from the knowledge that European governments have historically appeared willing to assist companies in distress, especially ‘national champions’ and economically important employers. However, in light of the current sovereign crisis, we think future credit spreads will have to reflect this loss of implicit sovereign support.
These reasons leave us feeling cautious about the potential for additional re-pricing of credit risk in European non-financials. We expect credit spreads to remain wide globally, but Europe seems especially vulnerable until a more robust response to the sovereign crisis emerges. Even in the best case scenario, Europe is likely to be in a recession, and the risks to that view are mostly to the downside.
In short, we think the direction in European high yield spreads is still wider, not tighter. We recommend buying protection on iTraxx Xover S16 for a spread target of 950bp. Assuming an average DV01of around 3.6 and a holding period of 3 months, the trade has a (fully funded) potential return of 4.5%.
2. Short 10-yr German Bunds for a target of 2.8% (open at 2.3%) and a potential return of +4.5%, stop 2.0%
On our long-held central view, funding pressures and the deterioration of the economic outlook will act as a ‘forcing mechanism’, leading to an agreement on a deeper fiscal integration of the Euro area, possibly in stages, involving budgetary rules supported by effective sanctions. Such an agreement on the regulation of fiscal flows should in turn pave the way to a partial ‘mutualisation’ of the existing debt stocks. Many options are on the table on how to achieve this, either explicitly (and ideas range from a co-investment fund seeded by EMU members on a pro-rata basis to a joint and several ‘redemption fund’) or indirectly via the ECB’s balance sheet. In both cases, this would result in a one-off transfer of credit risk to the ‘core’ countries, and a relaxation of systemic tensions which have led to a very pronounced flight-to-quality. Once a deal on fiscal flows is reached, we would also expect the ECB to adopt a more forceful response aimed at reducing funding costs and support the deleveraging of public and financial sector balance sheets. Against this backdrop, we recommend being outright short 10-yr German bund yields, but the position can also be expressed against corresponding maturity EONIA. We also like the ‘asymmetry’ of the trade: in a Euro-area ‘break-up’ tail scenario, the financial sector in the creditor ‘core’ countries will be confronted with severe impairments in their foreign holdings, which would worsen the state’s fiscal position. And in the middle ground between these two outcomes, where we find ourselves now, the ECB will be intermediating growing intra-Euro system imbalances. Through this monetary channel at the heart of EMU, the ‘shadow’ credit risk of the core countries is already rising, and at an increasingly rapid pace.
3. Go long EUR/CHF for a target of 1.35 (opened at roughly 1.2260) and a potential return of 11% including carry, stop at 1.20
With risky asset correlations strongly affecting FX markets, it is difficult to find exchange rate crosses that offer asymmetric expected returns. One strategy that we have been advocating to mitigate this problem is to look for those currencies that are strongly affected by policymakers. The Swiss National Bank is currently committed to keeping the EUR/CHF exchange rate above 1.20. This policy of quantitative easing is consistent with the rapid slowing of the Swiss economy and deflationary pressures. We see two scenarios in which this recommendation could work. First, continued weakening of Swiss activity, possibly linked to a deepening in the Euro-area crisis, could force the SNB to ease even more aggressively via a raised intervention level, which we now project at 1.30. Second, the (partial) resolution of sovereign tensions could trigger the reversal of some safe-haven flows into the CHF. Overall, it appears there are several scenarios, which could lead to a notable move higher in EUR/CHF, while the downside risks appear limited.
4. Long Canadian equities (S&P TSX) vs Japanese equities (Nikkei), FX unhedged for a target of 120 (opened at 100) and a potential return of 20%, stop at 90
In equities, we recommend a long position in Canadian equities via the S&P TSX relative to Japanese equities via the Nikkei, FX unhedged. This relative value trade, with an embedded long CAD/JPY leg as well, can be tracked on Bloomberg with the custom ticker .TSXNKY. Indexed at 100 on the Canadian close of November 30, 2011, we have a +20% target and a -10% stop loss on this top trade.
We like this pair trade for four reasons:
- With a bullish view on the commodity complex, and energy prices in particular, the Canadian equity market ought to be a clear beneficiary given its significant energy and materials weights (both a bit less than 25%). However, as our Commodity team has pointed out, energy upside is as much about supply-side constraints and lean inventories owing to concerns about the sustainability of global growth, as it is about resilience in some of the emerging markets. But given the unresolved risks in Europe, and our expectations for a recession there, we do not want to be outright long equities. And we are using the Japanese market, which is historically cyclical but with much smaller weights in commodity producing sectors (around 7.5% in materials and <1% in energy), to hedge out both cyclical exposure and broad ‘equity risk’, while leaving commodity exposure intact.
- The resulting equity pair has, over the last several years, tracked energy prices quite closely. More recently, over the last month or so, the equity pair has lagged the crude oil rally, providing an attractive entry point. Given our 6-month and 12-month WTI forecast of $113.5./bbl and $120/bbl respectively, and combined with the recent underperformance on the equity side, we think that a 20% move higher in Canada vs. Japan is about commensurate with the six-month oil target. Compared with a ‘long-only’ implementation, our chosen pair trade has a more moderate (annualised) volatility of about 20%, resulting in an attractive risk/reward profile for this trade, over the next six months.
- Apart from reflecting an upbeat near-term commodity view, this pair trade also reflects our forecast views on divergent currency paths. Our FX forecasts call for significant CAD appreciation relative to the USD, while our expected Yen profile is fairly flat. By implementing the trade in an FX unhedged way—which can be done via ETFs—we implicitly recommend going long CAD/JPY too.
- While we recognise that the Euro-area situation remains a source of elevated volatility in risky assets, the structure we are recommending is less levered to these risks. The reasons are twofold. First, the relative-trade nature of this trade ‘hedges away’ common dependence on events in Europe. And, second, over the last year the correlation of Canadian and Japanese equity markets with European financials was among the lowest in developed markets. It is also worth noting that Canadian financials fared reasonably well during the financials crisis of 2008.
5. Long a Global Rebalancing Basket (CNY, MYR versus GBP, USD) for a target of 107 (opened at 100) and a potential return of 7%, stop at 98
Large current account surpluses, and related signs of excessive FX reserve accumulation, are an important feature of persisting global imbalances. In particular in Asia, a number of countries record large surpluses in combination with heavily managed exchange rates and persistent inflation pressures. The currencies of these countries remain strong candidates for additional nominal appreciation. The CNY and MYR are typical examples, with the latter adding commodity exposure to the appreciation pressures.
Another feature of global imbalances is that a number of developed countries struggle to support domestic demand since the global credit crisis. In response, some of these countries have shifted towards extremely accommodative monetary policies and substantial QE, which exerts downside pressure on the respective currencies. The Fed and the Bank of England have been particularly proactive and hence the USD and GBP could remain under downside pressure. Both countries also continue to record current account deficits.
Combining the two angles suggests that a basket of long CNY, MYR versus GBP, USD would likely benefit from underlying equilibrium pressures towards global rebalancing, while displaying relatively little correlation to swings in broader risk aversion. We would implement the CNY and MYR legs via 1-year NDFs (expiring on 3 December 2012, trading at about 6.42 and 3.19 respectively.
6. Long July 2012 ICE Brent Crude Oil futures for a target of $120/bbl (opened at $107/bbl) and a potential return of 12%, stop at $100/bbl
As the downside risk from the European debt crisis has intensified, so has the oil market’s incentive to draw down inventories ahead of the threatened global economic recession. In particular, in its attempt to price in the potential that the European debt crisis may trigger a new global economic recession, the oil market continues to set crude oil prices too low to clear the tight physical markets, leading oil inventories to reach exceptionally low levels for the time of year. In the first three quarters of 2011 (latest available data), OECD total petroleum inventories drew by 225,000 b/d more than normal. This implies that despite Brent crude oil prices, which averaged $111.50/bbl over the same time period, current demand still exceeded the available supply. We estimate that Bent crude oil prices would have needed to average $130/bbl to restrain demand in line with supply. Further, in the absence of the IEA coordinated release of 35.5 million barrels of government inventories this summer, Brent crude oil prices would likely have needed to average $140/bbl to keep demand in line with supply.
Of course, the market had ample inventory cover from 2011Q1-2011Q3, and so the market could balance by drawing inventories rather than restraining demand. However, with inventories now exceptionally tight outside of the US, and US inventories drawing rapidly, we believe that this draw on oil inventories cannot be sustained and oil demand must be restrained either through the feared sharp decline in world economic growth, or higher crude oil prices.
Consequently, while the downside risk from the European debt crisis has increased, the upside risk to oil prices has also increased as the low level of inventories and currently tight supply-demand balance is leaving the oil market exceptionally vulnerable to supply disappointments or better-than-expected demand. Interestingly, while the oil market has spent much of 2011H2 drawing parallels to 2008H2, the more relevant parallel may prove to be between 2011H2 and 2007H2, when extremely tight physical markets set the stage for crude oil prices to rise by almost 50% in 2008H1 to a record high over $145/bbl even though the US economy had fallen into recession, much as we think the European economy is doing now
And the reasoning for this bearishness:
Another Two Years of Sub-Par Growth in Advanced Economies
The overall story is one in which the features of a post-bust recovery remain critical for understanding the medium-term global outlook. The US and several major developed economies are still facing the headwinds of private-sector deleveraging and budgetary consolidation in the public sector. That combination is likely to mean another two years of sub-par growth in major advanced economies, continued high unemployment and spare capacity, and a fresh round of policy responses, including further moves towards unconventional options.
EM Operating Relatively Close to Capacity
Free from some of the headwinds in the developed world, many EMs are operating relatively close to capacity, with inflation only just beginning to cool from elevated levels. Policy is gradually shifting towards preventing slower growth, and we think it will move further in that direction, helping to preserve their relative resilience. At the same time, supply-constrained commodity markets—particularly in oil—mean that even moderate global growth is enough to put upward pressure on commodity prices, despite significant slack in many other sectors.
Continued Intensification of the Euro-area Crisis
For the world as a whole, our forecast for real GDP growth in 2012 is 3.2% (down from 3.4%) and 4.1% for 2013. But the near-term uncertainties around our central forecasts are particularly large given the continued intensification of the Euro-area crisis. How the global economy actually evolves will depend on how that process plays out and the extent to which problems here transmit to the rest of the world.
Deeper Recession in Euro-area, Slowdown in US, Below Trend Growth in China
We now expect a deeper recession in the Euro area. Our baseline is for real GDP to fall at a rate of about 0.5% (or 2% annualised) in the present quarter and early 2012, which corresponds to the deepest part of the 1992-1993 recession in the Euro area. For 2012 as a whole, we expect a decline real GDP in the Euro area of 0.8%. Our baseline is for activity to stabilise towards the end of 2012, and expand by a modest 0.7% in 2013, but this is conditional on some major economic policy changes in the Euro area.
The deterioration in the Euro area has led us to downgrade our forecasts for countries that are heavily exposed to the region via foreign trade and/or the financial system. Specifically, we now expect mild recessions in the UK, Scandinavia and parts of Central and Eastern Europe. We continue to expect a growth slowdown in the US, as well as below-trend (but still decent) growth in China.
A Cautious Investment Picture, Highly Conditional on Policy Further Out
The Euro-area economic and financial risks are likely to remain centre-stage for now, and the battle between market pressure and the potential policy reaction is likely to intensify in the near term. So our strongest market views are based around the notion that this pressure will dominate early on. We envisage further near-term downside for European cyclical assets, increased banking system stress and continued pressure in European sovereign bond markets, extending to the core economies.
In Europe itself, we are forecasting notable downside in equity markets over the next three months (around -16%), and our near-term equity views in all of the major regions are relatively downbeat and have a defensive flavour, emphasising areas with strong balance sheets, low exposure to Europe and relatively low cyclicality. This applies even in areas (like Asia) where our economic forecasts for the year as a whole are still quite benign.
Beyond that, much depends on how policymakers then respond to that pressure. We currently expect improved performance in markets (higher equities, higher bond yields and a stronger Euro) beyond three months. And we can envisage taking a clear, constructive view across the markets at some point in the next few months, particularly if things deteriorate rapidly first. This general profile of near-term market turbulence followed by eventual recovery is consistent with the central profile in our economic forecasts. But it is important to understand that, more than usual, this is a conditional forecast and one that may require significant policy action for us to stick with it. And somewhat similar to a market version of Newton’s first law, we think in this environment the most sensible position is to stay structurally cautious unless a sufficient policy response is forthcoming.
Largest Upside Potential in NJA Equities 12 months out
The extent of performance in the second half of the year—even with some resolution of European issues—also varies by market. In equities, we envisage the largest upside potential ultimately in Non-Japan Asia (NJA), given the combinations of undemanding valuations and a still-benign central economic forecast for China. In the US and Europe, we think the upside through the year is likely to be more limited as sluggish economies, fiscal restraint and deleveraging pressures dominate. But even here there may be pockets of the market that could surprise positively once things stabilise: equities exposed to housing and automobile sales in the US, where activity levels are especially depressed, and consumer equities in the UK following the reversal of the intense squeeze on disposable incomes that has occurred.
Gradual Rise in Bond Yields
In government bond markets, working with the assumption that activity picks up in the second half of the year, but policy remains easy—with no run-off in central bank asset portfolios and only moderate inflation—bond yields should rise gradually. At current levels, they are below what a macro model based on inflation, growth and short-term rates would imply for almost all G10 countries. We maintain our conviction in the view that we have held since June that 10-year US Treasuries will not fall below 2% other than temporarily. We expect yields in the US to end 2012 at 2.5% and reach 3.3% by the end of 2013 as activity recovers and a fiscal risk premium is built in. For some of the more cyclical economies (UK, Canada, Australia), we expect yields to stay stable in the first half of 2012, with a relatively steeper sell-off in the second half as growth recovers and yields move back towards their macro equilibrium.
We expect German Bund yields to surpass what a macro model (such as our Sudoku) would imply, reflecting the assumption of a partial ‘mutualisation’ of Euro-area sovereign debt. This suggests that German 10-yr yields would be at 2.75% by end-2012 and at 3.25% by end-2013 (roughly 25bp above forwards and the model), with the risk that the move to 2.75% happens even faster.
FX: Euro-area Crisis vs Dollar Downtrend
In currencies, very high cross-asset correlations suggest that the trajectory of most crosses will reflect to a large extent the gyration of the Euro-area crisis. In that respect, it is possible that cyclically-correlated currencies will continue to see more weakness in the near term, maybe even substantially. However, if our central assumption of a subsequent policy response materialises, the unwinding of already very stretched long USD positions would likely become the dominating market dynamic. This would be visible in broad USD weakness, which remains the main theme of our revised forecasts (see table). Moreover, the latest trends in cross-border capital flows suggest that the USD continues to face underlying current account funding pressures, which have been temporarily masked by the deterioration in risk sentiment. By contrast, the portfolio flow situation in the Euro area actually improved on increased repatriation from Euro-area investors.
Within the scenario of a successful European policy response, EMEA currencies would likely rally relatively less, given their particularly strong trade and financial linkages with the Euro area. Some LATAM currencies could also continue to underperform due to financial sector connections to the Euro area. Among the outperformers, resilient Asian growth and barely contained inflation pressures will likely maintain substantial appreciation pressure for Asian surplus currencies. ‘Wall of Money’ flows could become a challenge again for many central banks in the region. Among major currencies, we expect FX markets to remain strongly influenced by policy action, such as the intervention in EUR/CHF and $/JPY, or continued QE by the Fed and the BoE.
We Continue to Forecast Higher Oil Prices
Partial resilience in global growth and the tightness of energy markets in particular means that we also continue to forecast higher oil prices. Of course, significant additional downside to the global growth picture would eventually change that story. But given the physical nature of those markets, this is one place where current reality, not future risks, could determine pricing even in the shorter term.