Nomura Skeptical On Bullish Consensus
Last week we heard from Nomura's bearded bear as Bob Janjuah restated his less-then-optimistic scenario for the global economy. Today his partner-in-crime, Kevin Gaynor, takes on the bullish consensus cognoscenti's three mutually supportive themes in his usual skeptical manner. While he respects the market's potential view that fundamentals, flow, valuation, and sentiment seem aligned for meaningful outperformance, it seems actual positioning does not reflect this (yet). Taking on each of the three bullish threads (EM policy shift as inflation slows, ECB has done and will do more QE, and US decoupling), the strategist teases out the reality and what is priced in as he does not see this as the March-2009-equivalent 'big-one' in rerisking (warranting concerns on chasing here).
Market Ponders Three Bullish Themes
Kevin Gaynor, Nomura
The consensus cognoscenti have three mutually supportive themes that explain the bullish risk tone in this critical quarter for fundamentals.
1. EM policy is poised to decisively shift tack as inflation falls back faster than expected. As such, this theme suggests, unless the activity data really accelerate to the downside we should look through this to a rebound in H2. Basic materials and EM risk assets should be the winners.
2. The ECB has done QE. It just took us a while to understand that the LTRO was QE by another name. As such, this theme suggests, the funding tail risk in the euro area has been removed, and so even if the economy slows further an imminent hard landing is now no longer a central risk. Peripheral debt is the place to be positioned. Oh, and ratings action doesn’t matter because the banking sector will buy government debt with ECB loans and earn their way to acceptable Tier 1 ratios - so buy financials.
3. The US has decoupled from slowing EM and EU growth and domestic demand is poised to take off. As such, this theme suggests, rates are vulnerable to a repricing, USD is attractive and one should prefer to be long the equity part of the balance sheet vs the bond part as medium-term growth expectations increase and corporates put their cash pile to work. Financials, trading at substantial discounts to book, should reprice higher.
Given this supportive macro backdrop positioning, sentiment and seasonal flows are seen as supportive for risk. Thus, we have arrived at a March 2009 moment where fundamentals, flow, valuation and sentiment stars are aligned for a meaningful further outperformance of equities versus rates and a crushing of vols. This is still an emerging view among investors we speak to, and as such it is still gathering steam. We do not get the sense that asset allocations have shifted toward this view from conversations or flow information.
As the team otherwise known as the sceptical strategists we must pay respect to this alignment of themes and factors. No one ever said markets should not be respected and we are not arrogant enough to claim total dominion over owning the "right view". Equally, given our moniker, approach and reputation we owe you, dear reader, a duty of care to ask "what could go wrong?"
Let’s take each strand in turn and consider the evidence and balance of risks before considering what has already been priced in and the backdrop for asset returns.
The ECB has done QE
The ECB would argue that it hasn’t! Anyway, regardless of the description the upshot of the LTRO, SMP and the next round of LTRO is now seen as being a source of primary market funding for governments via their own local banking sectors. By this reasoning unlimited cheap 3-year collateralised funding from the central bank prompts regional banks to buy national debt at auctions. Whether or not this is with implicit or explicit political support is probably not too important. However, a new nexus has opened up in this view including the ECB, national governments and national banks. They are essentially seen as one balance sheet. Therefore new issues are strongly supported via national banks, spreads narrow, financial stocks rally and the scene is set for the capital raising required by June. For pension funds underweight the bonds compared with their indices’ performance tracking error pressures mean they are forced to re-enter peripheral bond positions and if not there is a steady shift in the holdings of the stock of the debt toward national entities as re-financing proceeds.
Who knows, the implied sequential narrowing of spreads may prompt margin reductions and smaller haircuts at the ECB, creating a self-fulfilling spiral of tighter spreads, easier market access and financials outperformance.
The downsides to this view (some have called it a new Ponzi financing scheme) are several from the broader perspective. It is another form of financial repression, it looks and feels like a move toward a controlled market that is deviating from fundamentals and, to the extent that risk-weighted assets on the part of the euro area banking industry are being reduced, it implies a larger share of government paper in bank assets at the expense of other types of asset holdings – cannibalising or crowding out private domestic and international holdings. Hopefully interest rates will never have to rise or the LTROs stop. Nevertheless, we see a risk that spreads continue to do better than expected, forcing non-nationals to re-enter along with domestics. The alternative is substantially worse (think back two months).
The limiting factors to this scheme are threefold.
First, countries like Spain are still in current account deficit and require foreign financing each month to sustain that deficit. Someone must continue to finance the economy and if foreign banks refuse to roll over real estate loans (a good deal of commercial loans are coming due over the next year) then domestic financing needs will increase not decrease.
Second, the domestic banking sector in many peripheral economies cannot in extremis buy all the issuance, however much is repo’d with the ECB, since they have assets they will need to sell to finance this transaction, and long before they got to that point the equity market and analysts will have twigged what is going on (banks becoming levered government bond funds).
Third, the fundamentals on growth will act as referee on fiscal sustainability – and here we continue to feel that the euro area will struggle to provide positive growth this year or indeed for several years. As such the debt capacity of euro-area countries (capitalising up growth, real cost of funding and asset values etc) is lower even with lower bond yields. Deteriorating fundamentals may simply prompt remaining foreign holders to sell at these new attractive levels rather than build positions.
For timing purposes, we think euro-area data disappointments will begin to grow during this quarter and into Q2. However, if the rest of the world (US now and Asia later) is seen to be at the cusp of a turnaround to the upside then naturally the scheme will have a better chance of working. A weaker euro certainly helps. But if our core view is correct then the execution by European politicians of their commitments becomes exceedingly important for this theme to proceed. The persistent statements that Greece is unique will be stress tested toward the end of the quarter. The authorities must do anything possible to avoid a mistake that promotes concerns that other member states may seek a similar restructuring. This remains a difficult balancing act since meaningful restructuring raises the spectre of an involuntary exchange – which sets a precedent – whereas non-meaningful restructuring would do little to alleviate Greece’s plight thereby increasing the risk of further involuntary restructuring later. All the while the clock is ticking with regard to the next disbursement.
Regardless of the cost of capital for the government sector there are two other points worth making. Europe has failed to come up with a credible plan for growth, and indeed the plans to re-establish bond market credibility indicate weak growth for a long period. To that extent the euro area may indeed become less of a swing factor for global growth – in other words growth stability is welcome from a global perspective even if it is at a weak trend rate. Second, we will be interested to see how a deeper tax and spend union will work when Germany is abandoning its nuclear power industry and France is re-investing in its, how the quite different ethos of the defense establishments would work (offensive nuclear capability in one but not the other for example), and how national laws around for example restrictions on wearing symbols of religious belief vs the Basic Law’s strictures on personal freedom could be combined. We are, of course, being deliberately disingenuous to make an important point – that the cultural histories and proclivities of even the two biggest proponents of political union are quite different, making anything beyond the simplest co-mingling of fiscal resources seem unlikely in this generation.
The lack of a growth agenda and real political momentum suggests to us that the euro area, shifting as it is toward a big current account surplus, flat-lining population/labour force growth and remaining overcapacity in cross-border banking is aimed toward a managed decline in its ambitions for growth and global influence. Managed stability appears the order of the day for the core and thus it is one of the key low long-term real yield regions. For the periphery a yo-yo bond market, over-capacity and high unit labour costs indicate persistently disappointing fiscal performance (partly because of the mooted supply-side reform) and naturally a shift toward a larger domestic private sector funding over national government debt. Other countries have gone the same route and survived, but it is not a bullish environment for long-term equity investors.
EM policy acceleration/reversal
This is reasonably simple and reflects something we wrote about last year – higher uncertainty owing to the euro-area outlook reduces uncertainty about policy easing elsewhere – in particular EM. The recent increased rate of slowdown in EM headline inflation rates adds grease to this view and so being long short-rates in these areas has paid off.
However, there is quite a leap from predicting a market acceleration in the pace of easing and currency devaluation to ascribing a higher probability of a growth rebound. There are three considerations.
First, in terms of the order/inventory balances it appears from our colleagues in Asia in particular that excess inventories are substantial and will restrain production unless order flows recover smartly. The implication is that the data will remain weak.
Second, the balance sheet situation of the banking, real estate and household sectors suggests that a period of deleveraging is likely (not to mention healthy) and so lower real interest rates are not likely to warrant expectations of an outsized credit multiplier increase.
And third, related to the above, EM policymakers are trying to cool bubbles as well as restrain inflationary pressures while aiming for a soft landing. Thus, a decisive move to get “ahead of the curve” and take real yields down substantially – rather than tracking inflation lower – seems too linear an interpretation of the situation from our perspective.
It is worth saying, however, that the outflows from EM funds were large toward the latter part of last year (c.f. China’s reserve reversal in the last quarter) and so there is scope for inflows to respond to a healthier growth/inflation mix. In addition, it is encouraging that the performance of EM as an asset class is becoming less correlated in the sense that differentiation is taking place between for example parts of Eastern Europe (where rate cuts are not possible owing to currency concerns) and other EM risk.
US relative performance and surprise indices
And so to the “big one” – the apparent resurgence of US domestic demand. In our not quite “Year Ahead” document we pointed out that the US is doing a solid job of clearing its excess capital stock problem with the result that the economy should exhibit stability at a modest rate of growth. This is precisely what we think is happening. Is it the start of the big capital re-stocking and above-trend growth period that is out there in the future? Not yet is our view.
More tactically, the relative outperformance of US assets is now at “normal” cyclical highs, and our data surprise index is at its “normal” cyclical highs as well. Ordinarily we would be leaning against the bullish growth repricing on an absolute and relative basis therefore. The data will, again, decide and the next two months will be critical to establishing whether the economy is still accelerating or stabilising at this sub-trend pace. And the point about trend growth is critical since, on a simple extension of the pre-crisis trend, the US (and others of course) now has an output gap of somewhere around -11%. It is this “state variable” that is restricting the trend shift toward lower risk premia in equities and credit indices. If this is too big an estimate of the output gap then the trend level of GDP has fallen quasi permanently and so should the size of financial markets. If the output gap is this big then there is scope for a very strong non-inflationary recovery and bull run, but that would come at the expense of a default cycle.
When do you get bullish then?
As discussed in our New Year: New Resolutions? (16 December 2012), I personally think 2013 will be a positive year for US and global growth since the fundamentals backdrop should be much cleaner. We talked in that publication about strong beta rallies and the importance of market timing. On balance, and with due respect for these emerging market themes, we do not think this is the “big one” in terms of shifting asset allocations to structurally long risk and short core rates.