From Bob Janjuah of Nomura
Just Mild Indigestion Then…
Now that we are close to the end of Q3, and now that we have seen two consecutive weekly closes in the S&P500 index over 2000, it is time for an update. As per my last note risk-on did indeed play out over late Q2 and most of Q3, and the S&P500 hit the 1950/2000 zone I was targeting. We also saw a short period of counter-trend weakness in risk assets from about mid-July through to mid-August – this was the “belly-ache” I referred to in my previous note. Of course, the belly-ache was more like mild indigestion as the risk sell-off was at the shallower end of expectations – the Dax sold off well over 10% from peak-to-trough during July/August. A material move but well inside the worst case expectation of an “up to 20%” correction. And, as I also expected, the response from policymakers to this deflationary weakness was predictable – promises of looser monetary policy for longer, with the ECB leading the way in delivery. Since mid-August, when policymakers used Jackson Hole to give us their newest reason for keeping monetary policy looser for longer (wage inflation), markets have begun the late Q3/Q4 risk-on rally that I also wrote about.
What now? Well, with the consecutive weekly S&P 500 closes above 2000 my outlook for markets is as follows:
1 – Next 3 to 4 weeks: We could see a short period of weakness in risk assets. The S&P could fall 5% from the current 2000 level, with the 1905 level acting as a strong floor. Since mid-August markets have powered ahead in an almost parabolic-like fashion – and when markets move too far in too short a period of time, there is normally some payback. We have priced in a lot of good news, particularly around some key geo-political issues (of course, nothing has actually been “fixed”) and we have priced in a lot of central bank support. Some will suggest that global growth is driving markets, but my analysis and my discussions with clients make it clear to me that global growth remains weak and insufficient, and instead central banks are merely promising to either persist with or even add more fuel to the easy-money-driven speculative asset bubble fires all around the world. The core deflation and growth weakness in the eurozone and Japan, as well as the slowdown now occurring in China easily offset any upside in the US, which itself is set to deliver far less growth in 2014 than was forecast by both the Fed and the street consensus at the outset of the year. The US is the shining light to the growth bulls – but with 10-year UST yields at close to 2.4% and 30-year yields at 3.2% it seems to me that the bond market is not too worried about strong growth or inflation.
2 – Next 3 to 4 months: I would use any risk asset weakness over the balance of September and early October as an opportunity to BUY risk into year-end/early 2015. I don’t expect huge gains (5%, maybe up to 10%), and on the other side a weekly close below 1905 in the S&P would get me excited again, but on balance I feel that beyond the next three to four weeks, I am mildly bullish risk on a three- to four-month timeframe. The drivers are likely to be central banks, as well as the usual seasonality factor which tends to drive risk assets up into year-end. I have long expected outright ECB QE, and we basically have that now, but I still think the ECB will move to explicit QE in the next quarter or so. Of course that wont’ “fix” the real economy in the eurozone, but central banking easy money since 2009 has had very little to do with boosting the real economy and is much more about generating assets bubbles in the hope that it creates trickle-down consumption. That this policy has failed is clear – the biggest beneficiaries since March 2009 have been the owners of capital (i.e., those who least need wealth gains and who tend to hoard, not spend, such gains) very much at the expense of the masses (i.e., those who most need income and wealth, and who tend to spend and not hoard). Furthermore, and this is very much the view of many of my clients and not the house view, Abe-nomics is either not delivering and/or is in danger of stalling, and Abe’s popular support is being eroded. On the basis that progress on two out of the three arrows is minimal at best, I fully expect another round of explicit easing statements and targets by the BOJ over the next quarter or so. In particular, further euro weakness should soon give way to JPY weakness, as a weaker euro, aimed at boosting the German export economy, is likely to seriously damage Japanese exports. Competitive devaluations are a zero-sum game but the only response to weak global demand. Beyond the euro and JPY, the Chinese currency remains my big concern over the next year. And of course, all of this also speaks to a stronger USD – the other side of the trade. But here I remain very uncomfortable as I do not see the US economy (the real economy, not financial asset prices) strong enough to offset the deflation it will experience as USD continues to climb. Which is why I do not expect the Fed to do anything on the rates/easy money front for a long time.
What else do we need to think about?
For the balance of this year, over and above the usual data flow and earnings, we need to bear in mind AQR (this is one of my drivers for explicit ECB QE). We should also assume that Mr Putin will not go away as a geo-political risk and, indeed, we should not be surprised if his relations with the West remain prickly. And nor should we underestimate the Sunni/Shi’ite crisis and the role of both the West and Russia in this region. And finally the Scottish referendum could be a big driver, not just for the UK, but for the eurozone and perhaps also as a global factor if the Scots vote Yes and we see significant market volatility as a consequence. Who knows, maybe the Scottish vote delivers the Sept/Oct short-term volatility I am expecting and which I would treat as a risk-buying opportunity on a three- to four-month basis (the caveat being a weekly close in the S&P500 below 1905).
What are my recommended trades?
On a three- to four-month horizon I expect more euro weakness, and a lot more JPY weakness vs the USD. I also really like peripheral eurozone bond spreads (to Bunds) on a three- to four-month and three- to four-year basis. I see break-up risk as unlikely for the foreseeable future. So I would recommend taking out any credit spread between say Portugal/Italy/Spain vs Germany – the ECB should provide all the support needed. Of course, the Scottish outcome may lead to more pushes for break-up and separatism in the eurozone, but for me, on balance owning longer-dated Portugal vs Bunds in particular seems potentially profitable. I continue to like corporate credit, particularly in Europe, and I would continue to focus my equity exposure to those big caps where stock buy-back programmes remain open, again particularly in Europe.
And a final word on the big turn
As I have said for at least a year now, until and unless we see a weekly close (ideally consecutive weekly closes) in the VIX index below 10, then I judge risk-on has more to go. We got close in June/early July, but we did not get there. I would expect that, if I am right about the next quarter or two, then VIX should hit this target during this timeframe. At that point, positioning for the big turn and reversal of large chunks of the nominal wealth/asset price gains since early 2009 would take over as my key investment strategy.