Today's futures pop on short-term bill auctions in Europe (that remain in a world of their own and should not be considered as anything but emergent in nature rather than indicative of investor demand) and ad hoc data in Germany that disconnects from any sense of reality in true economic environs only confirms Morgan Stanley's Mike Wilson's perspective that there still isn't much fear out there. We remain in the midst of a longer-term deleveraging cycle, of that there can be little argument in reality (unless of course exponential trends are natural) and as Wilson points out we are likely to remain in the wide trading range that we have been in the past two years - however, many investors appear to disagree (not the least of which the effusively exuberant 'Ace' Greenberg this morning). Few expect a correction more than 5-10%, Buy-lists are already in great demand, and put-call ratios remain muted. "Of course, this is what happens when an animal becomes conditioned to buy the dip in a pavlovian manner over years during which they have remain unscathed by some of the biggest financial risks we have ever witnessed. As the saying goes, “the only fools bigger than those that are playing are those that are watching.” Of course, having some Fed official speaking every other day to remind us they are there to save the day in the event of trouble helps perpetuate this unnatural one way market."
Integrating this far less sanguine view of the world with Ray Dalio's historical deleveraging context, the increasingly polarized US political environment, and China's inflation-taunting, Wilson suggests being long China and short US as China stabilizes the CNY just to make sure their soft-landing doesn't turn into a hard one - as a weaker currency 'enables' the beautiful deleveraging that exaggerates nominal growth via central bank repression. We can only imagine the look on Schumer's face as China starts to devalue (instead of revalue) and the major currency wars begin.
Beauty Contest
Last time I suggested we are still in the midst of a longer term deleveraging cycle; and therefore, we are likely to remain in the wide trading range we have been in the past 2 years. However, it appears many investors do not agree. First, I have received multiple emails the past few days suggesting that “2012 is NOT 2011.” This seems to be a growing refrain even as markets are correcting with the bears suggesting we will not see this correction exceed 5- 10%. I am getting requests for BUY lists after just a week of softness in US equities. Amazing. Perhaps more interesting than this anecdotal data is the observation that the Equity Put Call Ratio remains quite muted and below where we reached during the very brief selloff in early March (Exhibit 7). Suffice it to say, there isn’t much fear out there.
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Of course, this is what happens when an animal becomes conditioned to buy the dip in a pavlovian manner over years during which they have remain unscathed by some of the biggest financial risks we have ever witnessed. As the saying goes, “the only fools bigger than those that are playing are those that are watching.” Of course, having some Fed official speaking every other day to remind us they are there to save the day in the event of trouble helps perpetuate this unnatural one way market.
Ray Dalio of Bridgewater Associates recently published an excellent paper discussing our current saga in the context of significant historical deleveraging events. For those that have not read it, I recommend you do. The paper suggests that the experience of the United States during the period of 2009-Present has been the “most beautiful deleveraging on record.” This is because it has maintained the right mix of the following variables during the deleveraging process: 1) debt reduction, 2) austerity, 3) wealth transfers and 4) debt monetization (i.e. money printing/QE). The analysis presented in the paper is compelling and I see no reason todisagree with its commendation of the most recent US experience. Of course, there are no guarantees that that the US will be able to maintain this beautiful balance as the deleveraging process continues. After all, total (public & private) debt to GDP has barely budged from its highs, and so we have a long way to go. In my view, the biggest wildcards to a successful continuation of this process are 1) politics and 2) interference from other countries orchestrating their own deleveraging balance and/or recovery from the financial crisis.
Obviously, the political environment in the US is about as polarizing as it has ever been. The fact that we are in a Presidential election year probably allows us to avoid the big confrontation that will ultimately lead to a level of austerity (either bigger cuts to spending and/or tax hikes) that may ruin the beautiful balance we have achieved. However, 2013 is a different story as the fiscal cliff must be addressed in the context of a new debt ceiling and the threat of another US debt downgrade. Given that stocks are discounting machines, markets are unlikely to wait until the moment of truth before they start to worry about how these issues will be addressed. As for the second issue, I think it’s safe to say that other countries have noticed how much better the US has dealt with the deleveraging to date. Do you think they might want to adopt some of the same policies? We’ve already seen Europe get on board with the idea that it’s ok to write down debt and print money to pay for it.
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Furthermore, China may be ready to let credit grow again even if it risks higher inflation. However China may also understand the importance of currency in this rebalancing game. One of the most important components of a beautiful deleveraging is a weaker currency because it helps drive nominal growth as the central banks orchestrate the financial repression. Even China has seen a deterioration in its growth as Europe falls back into recession and US GDP grinds along at just 2%. Therefore, a pause in the long term re-valuation of the Chinese Yuan has got to be enticing. Apparently, that is exactly what is happening. Exhibit 8 shows how the CNYUSD has flattened out since the beginning of the year. Notice how the Chinese stock market out/underperforms US stocks when CNYUSD flattens/falls. I wouldn’t be surprised if the Chinese have decided to go on another period of CNYUSD flattening just to make sure their soft landing doesn’t turn into a hard one. After all, they deserve a chance to be “beautiful” too. Maybe going long China equities and shorting US equities makes some sense.