From Nomura's Bob Janjuah
In Bob's World USDs are not welcome
My last report (The Sceptical Strategists: Time to fade Jackson Hole) was published nearly two months ago, and after another hectic travel schedule here is an update.
1 – Overall, the issues leading to the 2007-09 crises are still present, and are even worsening in some places. Namely very large global, regional, sectoral and national imbalances (in areas such as incomes, earnings, wealth, trade and financial health); excessive levels of, and excessively narrow concentrations of, debt primarily in Western economies; and significant fat tail risks in the market when it comes to the price of and the levels of assumed volatility. It seems that collectively we learnt nothing from the 2007-09 experience, and the apparent solution to the crisis has been to implement more of the same policies that caused the mess in the first place.
2 – Therefore, as we have said throughout the past four years, we think the key drivers of markets and economies are still the cost of capital (CoC) and balance sheet (BS) strength/financial health. The rising CoC over 2006-09 led to exactly what it always leads to: slower growth, weaker earnings and incomes, and ultimately a default cycle and poor risk asset performance. Since early 2009, primarily through quantitative easing (QE), the CoC fell and has been artificially mispriced in our view since then. This lower CoC also had the usual consequences: more leverage, more debt, and artificially supported, or mispriced, (risky) asset valuations.
3 – As we have discussed previously, the key current global macro themes occupying the market are still:
- In emerging markets (EM) will there be a soft or a hard landing? There is no doubt that a landing is needed in order to address inflation problems, excessive and speculative asset bubbles, approaching cyclical capex peaks, and very real labour squeezes/positive output gaps. But what sort of landing this will be remains to be seen.
- In developed markets (DM) we expect, for the next few years, lower trend growth rates. Already excessive debt levels have worsened, and we continue to expect a weak U-shaped recovery in domestic sectors overlaid by a temporary and highly cyclical super-cycle in manufacturing based largely on demand from the big three EM nations, the BICs (Brazil, India and China).
- In Europe, although we do eventually expect a credible and sustainable solution to Europe?s excessive debt/insufficient equity problem, we expect the crisis to continue for a while yet.
To the above three themes we can now add two more. Firstly, the outlook for Japan after the tragedy, and how it may impact the global economy and any global asset allocation. Second, Arabic unrest/oil price spikes and how such price moves are affecting growth and inflation in both the DM (where growth is the bigger risk), and the EM world (where, in energy and food, inflation is the bigger risk).
Other than the recent shock in Japan, all of the above are clear iterations of the issues discussed in (1) above. Nomura analysts are constantly assessing the shorter-term and medium-term impacts of the triple tragedy in Japan. Of course the nuclear problems are ongoing, but for the Sceptical Strategists the longer-term risk is that Japanese repatriation of its huge net overseas asset position may be hastened by these events. In this context even Japan is an iteration of the problems and issues summarised in (1). Japan has been one of the biggest current account surplus economies for decades, and has as a result been supplying the global economy, especially in the DM, with large amounts of cheap capital. If repatriation becomes a meaningful trend over the next five to ten years as Japan seeks to “service” its domestic deficit and significant (gross – for now the current net position is comfortable) debt burden, then this repatriation will cause the CoC to rise globally. Those predicting the collapse of the Japanese economy should realise that the West is not just addicted to cheap capital from Chinese excess savings/reserves or from the Fed. It has also, over the decades, become very reliant on Japan?s exports of capital!
4 – Our secular asset allocation theme is unchanged – a rising CoC period is, broadly, a risk-off phase, where the strongest BS entities (be they corporate, financial, government or consumer) should relatively (at least) outperform. A falling CoC phase is broadly about risk-on and favours the weakest BS entities. The period from 2007 to early 2009 was a rising CoC, risk-off phase. Early 2009 to the present has been a falling CoC, risk-on phase, albeit punctured by some brutal sell-offs that ultimately forced the Fed into QE2. We strongly believe that the next major secular trend, which will likely begin in 2011 and last through 2012 and maybe even into 2014, will be a rising CoC, risk-off phase where the weakest BS entities will underperform the most.
5 – We discussed at length our tactical asset allocation themes in our previous report two months ago, and we now update them. The first big call we made in late January was that the risk-on trade, expressed via global equity indices, would reach a top of some form in February; we set the S&P 500 target for this February top at 1330/1350. This has worked out well, with the S&P 500 peaking so far this year at 1344 on 18th February. We then expected a (minimum 10%) sell-off in risk assets, with the key risk periods likely to be March and/or April. This call has also worked out well. From the February highs global equity markets sold off close to 10% into the mid-March lows, with some markets well over 10% down but with the US major indices down a little less than 10%. Thereafter we saw two possible paths, either the soft landing path or the hard landing path:
- In the soft landing scenario, where we expect voluntary global policy tightening, driven by EM, we would expect 1350 S&P to act as a ceiling, and this sell-off to end with a 20% fall (from the February) peak to (the end-Q2) trough. Such a sell-off would in our view create a very positive TACTICAL buying opportunity for risk, as it would be the ideal “pause that refreshes” and would take the pressure off global commodity prices, the building global inflation risks, stretched risk asset valuations, and reduce the pressure on rising bond yields in DM.
- Under the hard landing scenario we would expect global policymakers to make even more policy mistakes by failing to tighten, and even more worryingly, by accommodating price shocks, especially in EM. Under this scenario we would expect the 1220 support level to hold for the S&P in Q2 2011, and we would look instead for another melt-up in risk assets over Q2 2011, with the S&P peaking at 1400/1440 by end-Q2. This then would be followed by a very difficult and bearish H2 2011 for risk, as the melt-up in commodities, valuations, expectations, sentiment, inflation, positioning and bond yields would together give the perfect backdrop for a severe hard landing in risk assets. Key here is that QE3 would be delayed until late 2011/early 2012 because of the extremely negative impact that the Fed’s QE2 has had on inflation (globally) and the significant concerns already building about the Fed’s credibility. We think QE3 is still likely, but judge that risk asset markets and the US economy (notably unemployment) will have to worsen considerably before the Fed can make a “credible” case and garner consensus support for QE3. Our view is that over H2 2011, under the hard landing scenario things will get a lot worse. It seems to us that very large amounts of debt and money printing are being used to “buy” a recovery which itself has no real legs (in particular as EM – the BICs – are forced to slow because of their domestic inflation, thus stopping dead the global manufacturing super-cycle which is the only real source of strong growth in the US). And once QE2 stops and other such stimuli are also turned off (fiscal boosts have already had their day, in our view) we think the emperor?s new clothes will be revealed for what they are. Although in this hard landing scenario, in the initial melt-up we think the S&P 500 could reach 1400/1440 by end-Q2, by end-2011 it could be below 1000.
All the evidence of the past few weeks points to the “melt-up then hard landing” path as being the most likely, although for now 1220 and 1350 are still holding, so we still see some hope – albeit diminishing rapidly – for the soft landing outcome. To reiterate, four consecutive S&P 500 closes above 1350 would to us signal the melt-up (1400/1440 S&P 500 by end Q2 2011), to be followed by the hard landing in H2 2011 (1000/sub-1000 S&P 500). Equally, if 1350 provides resistance and the S&P 500 trades below 1220 on four consecutive closes, then in this soft landing path we would expect to see low-1000s on the S&P 500 by end-Q2 2011. The big difference is that under the soft landing path, we would be buyers (tactically, into year-end) of the S&P 500 in the mid-1000s, expecting a bounce back to the 1300s by year-end. Under the hard landing path, a 1000 – even a sub-1000 – S&P 500 would likely not entice us back into high beta DM risk, even tactically, let alone on a secular basis.
6 – Why are we so bearish under the hard landing outcome? The key is that the policy tools needed to respond to a hard landing now are very limited, in our view, perhaps even non-existent in DM (EM/stronger BS nations, e.g. Brazil, Australia, still have plenty of policy flexibility/tools). In the UK and euro zone, we see virtually zero credible policy options from here on in. We think the only “hope” for the West is another policy mistake – in the form of QE3 in the US. But as mentioned above, the “hurdle” over which Mr Bernanke would have to jump to get agreement for QE3 is now much higher because of both domestic and international concerns. So, almost by definition (for us) more QE3 is likely, but only once the situation has become really bad in markets (1000/sub 1000 S&P 500; the UR starts rising again; the hard landing). In our view, the Fed has already put at significant risk its independence and its credibility, which in turn risks leaving both the US dollar and US Treasuries unanchored and as increasingly risky claims on an increasingly risky sovereign balance sheet. We judge that QE3 would significantly increase such concerns.
7 – We think QE3 will be both unavoidable and a grave policy mistake in the hard landing outcome. We think it (QE3) is unavoidable because under this outcome, where we expect a significant slowdown in global growth in H2, driven by an EM slowdown and an end to the global super-cycle in manufacturing, it is the only „stimulative? policy option left, and Bernanke and Obama both seem fixated with stimulus, at any cost it seems. Once this slowdown is apparent it should quickly become obvious that risk asset valuations are way too high, only supported by both overly optimistic growth expectations, and, as a result of QE, by a mispriced CoC; that the Fed has destroyed its credibility; and that there is no, or nowhere near enough “sustainable” growth in the US, in the UK, or in any of the DM. And we think it would be a policy mistake because it would represent all-out debasement and monetisation, which would seriously risk the safe-haven/risk-free/reserve status of the US, of the US dollar and of US Treasuries. And this would only be made worse if the euro zone does indeed solve its problems over the rest of this year, as we expect. We feel that QE3 would risk a very negative outcome whereby US Treasuries start being priced as a risky credit asset (with real yields rising sharply) and where the US dollar would no longer be viewed as any sort of useful store of value. We find it extremely worrying that over the mid-February to mid-March global equity sell-off, where the drivers of the sell-off were not particularly US-centric, the US dollar nonetheless sold off over this period. This is the exact opposite of what has been seen for more than the past two years, and not what the market expected. We worry that it may reflect growing concerns about the US sovereign and US policymakers who may now be turning into the central risk. If this is the case, and, as a result of QE3 the US dollar and US Treasuries become unanchored and are no longer seen as the world?s risk-free assets nor as the ultimate stores of value, then the entire foundations for valuations in financial markets could be at risk.
8 – In summary, the key driver of market returns right now and since early 2009 has been the Fed and its “intentional” mispricing of the true CoC through QE, but we think the Fed is fast approaching the limits of its credibility. We think the Fed is asking investors:
- to lever up at the wrong price;
- to take on risk at the wrong price; and
- to do this at precisely the wrong time in the business cycle.
For this to succeed, the Fed needs to convince investors it can keep the QE-fed Ponzi growing forever, permanently misprice the true CoC without any negative or unintended consequences. The US housing market seems quite clearly to be rejecting this proposition, but the equity market in particular has not. History shows no successful precedent, so under the hard landing path, when the CoC and pricing of risk normalise, as we would fully expect them to, asset prices, especially equities, should be hit very hard. We see this starting in Q3 2011, and likely lasting through 2012/2013 and maybe even into 2014, with QE3 becoming the central risk/problem, rather than the apparent solution. In this significant down move we should expect new lows in weak BS DM and EM equities (not strong BS countries) as in these weak BS nations policymakers, especially the Fed, would likely have little/no credibility and no/extremely limited policy options left (we see QE3 as the Fed?s last big stand). And all it will have achieved in our view, since QE1 and especially QE2 was flagged, is to have encouraged many more investors to wrongly load up on risk, at the wrong price and at the wrong time.
Assuming that the QE3 option is eventually exercised (as we do under the hard landing outcome) and assuming it does what we fear to the credibility and status of the US, the US dollar and US Treasuries, then we think the result, most likely at some point between 2012 and 2014, will be major fx regime changes and significant paradigm shifts in global fx markets. As these changes and shifts occur, gold could perform very well, as could other scarce physical assets (possibly super prime real estate). And the highest quality (by BS strength) nominal corporate assets – top quality equities in other words – may at least on a relative basis (if not absolute) perform fairly well.