As Bob Janjuah, of Nomura, notes in his final dissertation of the year, our in-boxes are stuffed with all the good cheer of sell-side research outlooks. However, the bearded bear manages to cut through all the nuance to get to the six questions that need to be addressed in order to see your way successfully in 2012. With the US two-thirds of the way through the post-crisis workout phase while Europe remains only half-way through, and China a mere one-third through the necessary adjustments to less global imbalance, he is not a global uber-bear on every asset class as the net effect is modest global underlying demand and plenty of savings sloshing around looking for a home. The market will have to adjust further to an extended period of weakness in Europe, which will impact EM growth expectations and so the existential ursine strategist is skewing his macro expectations to the downside and with the market pricing a 'softish' global landing, there remains a considerable gap between downside risk potential and current expectations. Furthermore, Janjuah believes the upside is relatively self-limiting on the basis of commodity price pressures and the potential for property or asset bubble bursts - leaving upside limited and downside substantial.
Q1: Where are we in the post-crisis work-out?
The US economy is proceeding with its excess capital stock work-off when measured against either the labour force or GDP. It still looks to us like it will take another 12-18 months for the excess capital to be cleared. During this phase it remains a truism that aggregate net investment will remain modest, corporate cash holdings remain high, and that the private sector will still generate higher savings than investment. It is still unclear if the “clearing” level of the capital stock has actually fallen owing to changes in banking and financial regulation. Nevertheless, that backdrop remains supportive of quality non-financial credit, low real yields and weak aggregate equity performance. It’s worth noting that high private sector net saving should be offset by high government sector dissaving during this phase. The US policy mix, while generating a lot of angst, has allowed the US to hold things steady while this background adjustment occurs. Note: demand management policies are not able to generate a return to pre-crisis growth rates until the supply-side work-out is complete; hence the sequential aborted risk market take-offs.
The problem now is that parts of the euro area are in a very similar position but are being forced to adopt what we consider inappropriate policies from a macro point of view. Spain is a good example: who would doubt that the capital stock is some way above the long-run suitable level? As such, Spain and others are likely face only modest private sector demand for several years. A policy of fiscal tightening will only serve to increase the national saving/investment balance as the current account moves into surplus and international debt is paid down. We see this as a good thing but still think gradualism would be better than cold turkey. The added complexity is that the “clearing” level in the euro area is no longer well defined: a combination of rapid banking reform, Basle 2.5/3 and major uncertainty about supply-side and macro policy makes for an open-ended period of capex spending falls.
The final point on background work-out is about EM. China has built a lot of infrastructure since 2008 and we would argue is running some way ahead of the current warranted level. Capital deepening in EM is a good thing, but a period of modest capex looks more likely than a continuation of hyper capex growth. We don’t know as a market whether that will be sufficient to trigger non-linear balance sheet effects and a Chinese credit crunch, but certainly think Mr Market will have to romance the idea in the next 12 months.
Our conclusion is that we are two-thirds of the way through the adjustment in the US, half way through in the euro area (but without knowing the clearing level it’s impossible to be too precise) and one-third through in places like China. Net effect is modest global underlying demand and plenty of savings sloshing around looking for a home.
Q2: Where are we in the business cycle?
Clearly, while this period of work-out is going on, the global economy and its markets are particularly vulnerable to new shocks given current policy settings and the state of weaker paticipants’ balance sheets. For a while now we have been talking about an EM slowdown and hard defaults in the euro area. Both risks are now centre stage for investors.
Two themes emerge from a detailed reading of our economics team’s year-ahead forecasts. First, that the global economy is slowing, led as much by domestic demand in emerging economies as the outlook for the euro area. Fiscal drag, the echo of higher commodity prices and tighter EM policy combined with banking sector deleveraging, has led our economics team to move its forecasts toward weak H1 2012 growth before a reasonably robust recovery in H2 2012. Naturally, this would lead one to be overweight rates and underweight risk now.
But the second overarching theme that emerges is one of contingent risk. Almost every country forecast highlights the evolution of the euro-area economy as the key foreseen risk. And importantly, the gap between the muddle-through shallow recession scenario and full-blown hard landing and cost of capital shock is substantial in the simulation runs provided not just for the euro area but for all economies. Our house opinion is that the euro area does not matter a great deal to global fundamentals, until it matters a great deal. This is classic non-linear gap risk.
One area that is useful to think about is how deleveraging in the euro area will play out in terms of the aggregate data and the euro area’s surplus. It seems to us that a cross-border deleveraging against the backdrop of high multinational corporate cash balances and modest funding requirements should primarily play out through the banking sector seeing a substantial and persistent jump in its funding costs in the current account deficit economies. And it is through this channel that the economy should be influenced via the household and SME sectors seeing a sequential tightening of credit availability and increased funding costs. Naturally if I have 100 large corporates that make up my equity market and I hit their funding costs I would expect a rapid impact. But if I have 5 million SMEs and 30 million households not all of them are looking to refinance at the same time and so I would expect a staggered impact on their effective cost of capital (it’s a bit like duration considerations for governments). Confidence and market pricing of course will not respond slowly.
Another consideration that hasn’t been given much air time is the supply-side flexibility of the euro area in comparison with other major economies. We can get a handle on this issue by comparing how long it takes for changes in growth to have their maximum impact on unemployment and in turn unemployment on inflation. The results are shown in Figure 3, with the maximum lag shown in months. The basic message is that taken over the past 20 years a movement in growth has taken six months to have its maximum impact on unemployment in the euro area and in turn it takes around 16 months for changes in unemployment to have their maximum impact on inflation. It therefore takes over two years for a growth shock to have its maximum impact on inflation, working via the labour and product markets. To put this in context, the US gets there in nine months, while the UK has fairly rapid labour market reactions but relatively slow wage/inflation reactions to unemployment.
What does this mean practically? The policy framework the euro area has adopted excludes high growth or high inflation as a way out of its debt/excess capital stock burden. Instead, we are moving toward a competitive realignment via supply-side adjustment. This is where the “sacrifice ratio” comes in – simply the output loss required to generate a 1% fall in inflation. The sacrifice ratio in the euro area is still higher than in the US and UK, and is particularly high in the periphery (not Ireland, though). Thus, if Spain et al are to compete their way into growth they will face a larger increase in unemployment than others before economic growth returns. Leaving aside the policy and political implications of this, the growth implications are clear – it should be weaker than that of other countries faced with a similar problem. Once the euro area starts adjusting its supply-it exhibits a super-tanker-style turning circle. In this scenario the euro area would shift into a current account surplus – another source of excess savings to the world.
Our conclusion is that the market will have to price an extended period of weak euro-area growth and downside risks to EM activity expectations. One thing we know from forecast history is that forecasts move predictably when the economy is slowing or accelerating. We would suggest that further forecast downgrades will come through over the next two quarters. We in macro strategy therefore retain negative skews to our expectation for growth versus the consensus next year.
Q3. What about policy?
An American colleague put the euro-area situation into stark relief recently, saying the euro area can either inflate its way out of trouble, grow its way out of trouble or default its way out of debt. Expansionary fiscal policy is clearly not an option; full-on unilateral central bank balance sheet expansion appears to be off the table unless significant further fiscal unity is created, which leaves the default or “debt holiday” option.
In any event, we can take some things for granted. The euro area remains a currency zone without a single financial market regulator, effective fiscal co-ordination or the institutional depth and breadth to cope with the current situation. We do not see this changing any time soon. So, our first policy conclusion is that there will be no effective resolution for markets for a considerable time. Therefore, rating and default risk etc remain high and rising as the fundamentals deteriorate over the course of the next 12 months.
The point about this path is that it is highly predictable, even if the exact details are not. The anticipated costs for policymakers of allowing this path to be taken are large, and confidence about being able to reverse course once on this path is small. Therefore, the conclusion is clear – avoid this path. Rational policymakers can solve backwards as well as the rest of us. And so it is rational for markets to price that this option will be avoided at all costs. But if the euro area is incapable for political and/or legal reasons from offering up the solution, it just increases our conviction about policy easing elsewhere and where idiosyncratic differences allow, including the introduction of QE again in the US.
For the euro area to matter to the global economy we have to assume a “policy error” will be made. Or that one of several variables makes itself felt, by which we mean ratings action (a central view for us is that some core euro-area economies will lose their AAA status) or peripheral politics (Greek elections; Finnish opposition). The policy error most seem to be pinning their hopes on is that the ECB fails to leverage its balance sheet in order to support fiscal adjustment and counteract euro-area bank deleveraging – let’s call it Quantitative Fiscal Support (QFS). As we have argued before (see The euro is dead; long live the euro, 11 November 2011) the sequencing of fiscal actions prior to QFS are actually quite clear but are unlikely to be delivered successfully soon.
However, as a firm we do not think the ECB will enter into unconditional QFS. Instead, we expect it to enter into standard Fed- and BoE-style QE when the economic fundamentals warrant it – i.e., falling inflation and falling inflation expectations.
Of equal importance are the policy decisions that will be made following the US election, the Chinese governance transition (likely to be the largest shift in personnel in many years), the Greek elections in February and the French elections in April and May. On the slate in the US is how fiscal policy will be tackled but possibly of more importance reform of the GSEs. China will be under pressure to address its monetary policy framework, possibly against the backdrop of substantial reform at the IMF and euro-area governance. These decisions will have long-lasting implications for the global supply chain, reserve growth and FX.
More pressing is regulatory pressure on the banking sector at a time of increased government and bank bond issuance as Basle 2.5 comes into force in January at least in the EU. Easier monetary policy against bank credit multiplier declines will be less effective than normal.
The conclusion is that we expect faster and deeper than currently priced in easing in EM, for the Fed, BoE and ECB to add more QE if required rather than pre-emptively. If EM gets "ahead of the curve" rather than matching the pace of slowdown with easing, this will be a positive surprise.
Q4. Is this all priced in?
Sort of. If we use quarterly global equity returns vs G7 government bond returns vs a proxy of G3 activity (using PMIs and the ISMs etc) then the market has done (as usual) an excellent job of anticipating turning points in activity. On this “dynamic” basis risk vs risk-free returns do not appear to have deviated materially from the business cycle. Indeed, the recent risk rally anticipated the recent pick-up in business confidence and is currently anticipating a further increase. On this basis then the aggregate market is not pricing in anything that the business confidence data hasn’t actually done. Now, we could have a perfectly valid debate about causality and the relationship between reported business conditions versus hard data which have been distorted by the post-earthquake/tsunami supply disruption. But my point is that taken globally and at the aggregate level of stocks/rates the market is not behaving irrationally. Naturally, business confidence as much as market confidence is being influenced by the policy uncertainty and other threats to the medium-term outlook for growth. But the point is that business confidence is going to be the determinant of capex and hiring plans.
In fact, if we take the euro area as an example, equity returns have been a reasonable reflection of how forecasts for the next 12 months are shifting. If we take our forecasts and the historical data for the acceleration and deceleration in GDP growth for the euro area and compare it with reported equity market earnings we get a good leading indicator.
On the basis of our base case quarterly forecasts for GDP, the euro area should see a 12-month delta in its growth rate of almost -5ppts, which would be consistent with the second largest contraction in earnings in the modern era before (based on our forecasts) the economy rebounds fairly smartly in H2 and 2013.
This may look rather aggressive and it is not our “House” forecast for earnings – I show the chart instead to highlight how a top-down investor might try to quantify earnings risk. Naturally, Mr Market has already jumped several steps ahead to price in something approaching this eventuality, albeit that to be fully consistent with our “House” GDP forecast there is some further downside. The noteworthy aspect is probably less about magnitude and more about timing. A trough in growth in Q1 should lead to a bounce from there on in risk assets and perhaps quite a robust one at that.
The conclusion is we think the market is pricing in a softish global landing, with a decent spread between the downside risks of a euro-area policy mistake being offset by expected stability in the US data and the expectation of monetary policy easing in EM and parts of DM. Most investors seem to have a waning expectation of decisive euro-area action.
Q5. What about market conditions?
Within Europe it is worth re-stating that we think liquidity conditions are unlikely to improve a great deal over the course of the year at least in cash assets. This would tend to further exacerbate basis volatility as hedging and positions are placed through derivatives. In one sense the cash market would behave as if capital controls were already in place - investors we reckon must consider their ability to reverse positions in the future as a key element to entering trades in the first place. In this sense, then, the market is likely to continue its bifurcation between effective hold-to-maturity strategies with high mark-to-market volatility.
Moreover, policymakers appear to be increasingly frustrated by their inability to get markets to "toe the line". This does increase concerns about further action to limit free capital movement against the backdrop of contract uncertainty. While regulatory and contract arbitrage opportunities should result, they will require intense scrutiny of contracts and national law.
Q6. So what is the outlook for investment strategy and style?
Taking all of the above into account, our conclusions are set out in Figure 8. So how do we invest over the course of the year? In many ways the themes have not changed very much at all. We continue to differentiate on the basis of balance sheet strength, cognisant of the policy-led high-beta squeezes that last for a while. We continue to see this as a volatile carry trade environment rather than a spread convergence environment, which implies large ranges that can be tactically positioned for. This is not a macro approach to investing, rather a core model of strong bottom-up credit work and equity analysis to identify those balance sheets with strength and low refinancing needs. The macro part of the story is to retain higher-than-normal liquidity levels to take advantage of the risk squeezes and sell-offs. For the year as a whole, quality should win out, with another key risk sell-off anticipated in Q1, before considerations about fundamental policy change after the political changeover in China and the US, combined with genuine clearing of excess capital lead to a deeper rethink on asset allocation.
The upside scenario is rather self-limiting via commodity prices and possibly re-emergent property prices and other bubbles in areas where QE liquidity has seeped in. So our boundaries are fairly clear. Upside is limited to the removal of negatives around the conditional risk of a euro-area policy mistake or unexpected event, whereas the downside is substantial if those conditions are met, all played out against a slowing business cycle and moderate underlying final demand.
Considering the core view as portrayed by our economic forecasts, it is clear that a recovery is expected into H2 on rather modest policy easing globally. However, it is precisely at this point that some important transitions will occur, as already referred to – the US, China and, indeed, the shaping of the EU’s new governance structure. Thus, even as the economic fundamentals may be stabilising with positive market deltas, we would be pushed into considering possibly the starkest policy differences in the US for a generation: the GSEs, the tax/spend mix; healthcare reform; global trade and FX policy; the fulfilment or not of Frank-Dodd.