John Taylor: "How Can A 5% Positive Forecast Coexist With Calls For A Recession, Including Our Own?"

Today a twofer from the head guys at FX concepts:

An Interesting Year Coming Up
By John R. Taylor, Jr., Chief Investment Officer

The market outlooks we are receiving for this next year are as diverse as we have ever seen. Our most conservative and highly qualified mainline economist is forecasting US growth at 5% for the second half of next year, lining up with most of the major bank economics departments. Talk to the analysts on the trading desks and you hear a very different tune. The financial markets are showing unusually bubblish valuations, ones that historically argue for sharp negative reversals. In fact there are so many investments with negative outlooks for returns that it is almost impossible to know where to put money. Trading desks, from senior dealers to market analysts, generally see trouble, and some see it immediately ahead. Forecasting shortcuts are not looking good. The Hindenburg Omen has been triggered and the Titanic Syndrome will probably follow – all it takes is one big down day in equities. As one might guess these are not positive signs in market lore. Another respected analyst has an Aunt Minnie condition to foretell disaster – of course, it too has been satisfied. Our valued consultant, Woody Brock, is negative for the long-run but more open to positive short term events. He has just written a research piece titled “Outside the Box”? Nope. There No Longer Is a Box that pretty much expresses our central thoughts. Despite many projections for rapid growth, we have to agree with Woody that the next few years will be dominated by a sovereign debt crisis in the West, growing power in the East, and “cognitive dissonance” among big global market and political actors. One result of this dissonance is the incredible range of forecasts we are seeing. A few weeks ago, we suggested in this letter (November 11) Fasten Your Seatbelt; and this seems even more appropriate now. Although it is an exciting time in which to live, it will be an incredibly dangerous one, and many will be losers.

How can a 5% positive forecast coexist with calls for a recession, including our own? First, various analysts weight inputs differently, which alters outputs, but more important some do not believe that the old policy inputs will bring the same results this time. Everyone has to start with the same GDP inputs: consumption, investment, government spending and net exports. Growth in late 2009 and 2010 was primarily a function of the increase in government spending with a little kick for net exports. For 2011 the very positive forecast, post the “tax compromise,” assumes that government spending will be a slight plus, that investment will rise as corporations are more secure about their tax status and the government’s attitude toward business, and that consumption will increase as people will feel more optimistic about job creation and happy with the wealth effect of Bernanke’s QE2. Even the bank economists do not see a positive in the net export category. Almost all agree that the government’s latest efforts to support the economy will have a more positive impact on 2011, but will increase the debt load, hurting 2012 and the following years. The issue really revolves around the impact these moves will have on consumption and investment, centering on job creation and “animal spirits.” Market oriented analysts point to the fact that positive wealth effect is more associated with house values not equities and that QE2 will not have the impact Bernanke expects – certainly the past 6 weeks lean that way. History shows that corporations will not spend their cash with capacity utilization this low. Because the Buy America Bonds were not included in the compromise, state finances should further deteriorate, by at least as much as the fiscal stimulus implied by the tax deal. Net-net, there is a strong argument that all four components of GDP will disappoint and that US growth will be negative or minimal for 2011. With equity markets and credit spreads priced for Goldilocks growth – cheap money is also key – the probabilities of disappointment are high. As any further fiscal push is unlikely in the US, and Europe is focused on austerity despite the collapsing  euro-debt markets, asset prices cannot climb from here.

And, next some observations on the USDJPY from Jonathan Clark

The Two Faces of the Japanese Yen

More than six weeks ago we posted a commentary titled ‘Japanese to Get an Early Emperor’s Birthday Present’ which argued the yen would weaken into this important holiday on December 23. The yen has been trading like other Asian currencies including the KRW and SGD and declined as interest rates in the US rose faster than those in most other countries. Concern about the latest bout of quantitative easing by the US has been overwhelmed by positive economic data. The movement in the interest rate differential exerts a significant influence on capital flows.

Although most of the time the Japanese yen correlates positively with the other currencies, a small percentage of the time the yen changes its  nature and not only trades in the same direction as the US dollar, but outperforms it. For this to occur not only do risk assets like equities have to decline, but the pace of the downmove must be aggressive. Under these conditions there is a shortage of US dollars and some of the capital invested abroad by the Japanese returns home.

It is clearly difficult to pinpoint when the Japanese yen will change its nature and become a strong currency, therefore we need to examine both the cycles in the currency as well as developments in the equity markets. We are receiving a disturbing amount of research attesting to the overvalued nature of equity markets and this usually precedes a strong downmove. Bullish sentiment is at its highest level since the NASDAQ bubble and the index is hovering just below the 2007 high. The recent rally in equities has been accompanied by anemic volume, the put-call ratio shows hedging is extremely low and unsophisticated investor sentiment is near record highs. There are numerous other signs that equities will weaken, but will the downmove be large and fast enough to cause the yen to strengthen?

The cycles argue that the dollar/yen has begun the final leg of its uptrend and the most likely time for a peak is the first half of next week. It should  trade to 84.80 at a minimum and possibly as high as 86.00 before peaking. We recommend selling dollar/yen into this rally as the dollar should then turn lower and decline into February. This overall weakness is likely to last into May. A close below 82.80 will signal it is headed lower, and a decline to the 77.00 area or further is then possible.