Looking Beyond Europe

As we come to terms with the new reality (or perhaps same old reality) that governments will do anything to maintain the status quo, Goldman Sachs took a step back this morning to consider what is worth focusing on in the medium-term. Obviously the European Summit proceedings impact their perspective, but less positively than one might expect as they expect slower global growth, a possible European recession, refocus on US data, Chinese policy responses, currency wars, and a balanced portfolio approach to risk.

Global Market Views: Looking Beyond Europe

Dominic Wilson

1    Europe remains the top issue on most investors’ radar screens. Last night's summit was broadly as expected, centred on a bank recap plan, a larger Greek haircut than originally planned and an EFSF insurance scheme (European Views). Lack of detail on the EFSF scheme was disappointing but proposals to use public guarantees to help unsecured bank funding and to establish a SPV to bring in outside money, while vague, are new. Although this may satisfy short-term market demands, we are skeptical that it represents a lasting resolution; hence, we can imagine renewed stresses from this source and still view the sovereign crisis as a source of risk. However, the more interesting question now may not be whether European risks are decisively resolved (which we doubt) but instead whether the market has again overestimated their spillover into real activity globally. On that front, the market may be focusing too little on a US economy that so far refuses to go into recession, and on the chances (finally) of a shift in Chinese policy. Neither is a source of dramatic good news, but the market has beaten down growth views in both areas. And it is here that we have begun to recommend some selective risk.


2    Almost every conversation we have had in the last months has started – and often ends – with Europe. European risk has been the key factor that has led us to be more cautious about markets in the past few months. It affected risk premia directly; ongoing stresses to the banking system – and broad financial conditions – have made it hard for us (or others) to be confident that the market would pay for resilience in current data, even with positive surprises, given a clear risk that financial pressures will lead to slower growth further forward. Our central case has been that European policy will make incremental but insufficient progress towards resolution, with the ECB balance sheet being used to backstop the system. The latest steps fit that pattern: better than where we were a few months ago, but insufficient to provide a decisive end to the problems, and light on details. What is still more open to question, however, is how much these financial pressures transmit to the real economy – something that has been our biggest focus since August.


3    Our own central forecast has been that the financial shock will push the Eurozone into mild recession by year-end; that the US will see some pressure from this source but is probably more likely to avoid recession; and that China will slow relatively less than feared as external demand pressures should bring a policy response. The European survey data has shown continued deceleration and is now consistent with only barely positive growth. However, as we have described, the market has priced significant forward growth weakness not just in Europe itself, but in some cases even more clearly in the US/Chinese and global growth picture. Even if Europe remains a significant source of financial risk, the longer the transmission to non-European economies fails to push them into sharper slowdowns, the more the market may become willing to separate some cyclical assets from the European dynamic, to a degree that it has not been willing to do in quite some time.


4    On that front, European preoccupations (positive and negative) may have partially obscured two developments. The first is the continuation of moderate, positive growth in the US economy. In absolute terms, the US economic news (broadly consistent with low positive growth) is still very disappointing. But it has been systematically better than expected (as our MAP indices show) and has not yet shown the kind of deceleration that many feared. Our Current Activity Indicator (CAI) shows that the broad set of data is consistent with GDP growth holding steady at a little better than 1% in the last month or two, a touch better than in August and not at this point in recessionary territory. Our forecasts look for GDP growth of only around 1% in Q4 too – a clear slowing from this morning’s Q3 print – but pretty close to the run rate that much of the data is already showing. What is striking is not that the data are strong (they aren’t), but that a recession that the market has periodically taken as a foregone conclusion is so far not appearing. The main near-term risk remains fiscal policy, where the November 23 Super-Committee deadline could still provide roadbumps.


5    The second issue is China’s growth and policy response. Most data show both that China’s growth has been below trend for several months, and that financial and credit conditions remain very tight, particularly for smaller firms. The September export data also show clearer signs that the slowdown in major trading partners is dampening growth. But while the slowdown is real, the market’s perception of that reality often seems multitudes worse and, puzzlingly, seems even more intense in the last month or so. Q3 GDP growth was again close to 9% and the latest HSBC PMI moved above 50 after three months below that level. There are also modest hints that the policy debate is shifting. Premier Wen has over the last few days placed somewhat greater emphasis on job creation – and stable money growth - while still reiterating the fight against inflation. These are subtle shifts, but they suggest that as the impact of tightening now bites, policymakers are becoming more balanced about the risks to the economy. We expect inflation to drop below 5% this quarter, easing the immediate constraint here. One of our big disagreements with some of the more bearish voices on China is that we view the tightness of credit conditions as an explicit policy choice, not an indicator of a system collapsing on itself. This means that it can be reversed in the short term if needed, even if the longer-term risks are increasing.


6    Neither the US nor the China story is particularly good in any absolute sense. But market pricing of growth in each area is already very depressed. The pricing of US cyclicals versus defensives, captured by our Wavefront Growth Basket, has looked – on our measures – to be consistent with a US recession for some time. We have argued that the market has priced more significant distress here – surprisingly – than in many other places. And the relative valuation of cyclicals to defensives globally tells a similar story. What is equally notable is that with the SPX retracing well over 50% of its peak-to-trough decline in the last few weeks, the Growth basket has lagged that rally and closed only around a quarter of its drop. So, despite the fact that we think it is the data – not European risk – that has been the clearest reason to feel somewhat better in the last month or two, the market has traded something closer to the reverse.? Noah Weisberger and team have recommended a fresh long position in Wavefront Growth this morning. This reflects the view that the market has room to relax about extreme growth risk, even though we are unwilling to call the "all clear" on financial risks.


7    Chinese assets have also shown dramatic underperformance over the last few months, despite the focus on Europe. A-shares made new lows last week. H-shares have underperformed the SPX substantially on a wide range of horizons: over the last 3 months, over the last year, since the US market lows of March 2009 and since the US market highs of October 2007. Copper markets were heavily impacted in August and September. China-sensitive cyclicals in the US have underperformed sharply since mid-July. And even the substantial drop in the DAX – usually attributed to its location in Europe – may have as much to do with the broad pressure on cyclical and China-dependent assets.  Intriguingly, however, the last couple of weeks have seen some reversal here. H-shares rallied on Wednesday even on the back of a tough US close and have had a big move overnight; A-shares are lagging but have also moved higher in the last week; copper prices have moved off their lows; and China-related US cyclicals have been outperforming modestly for a few weeks. These signs – coupled with a rising probability of a policy shift – deserve more attention than they have received so far.


8    Of course, policy shifts are not only appearing in China. US policymakers continue to edge towards further action. We expect next week’s FOMC meeting to deliver only modest changes. But the discussion both of extending FOMC projections to forecast the funds rate – one way of sending soft signals of an even more extended commitment to low rates – and of larger shifts to the monetary policy framework has picked up lately. What many of the new proposals being floated have in common is the willingness to consider more inflation, at least temporarily. We have suggested that a nominal GDP target accompanied by asset purchases would be the best option for the Fed to deliver further easing in policy. Yesterday’s Global Weekly runs through the main questions on this new debate. Credible shifts in this direction would push out the timing of tightening even further, with steeper curves beyond that, and would likely push real rate expectations down further still. A credible commitment of this kind would also presumably be good for equities and tend to weaken the currency. These asset price shifts would essentially involve the reversal of the constraints imposed by a so-called "liquidity trap".


9    While we are still not sure how far and how quickly the major economies will head in this direction, we think it is important to think through the implications in advance. Currency insights are intriguing in two directions with this framework. The first general insight is that in the limit, if developed economies remain weak and interest rates extremely low, major currencies may begin to price off the notion of who will be quickest to embrace the view of aiming squarely for more inflationary policy. In that environment, both the UK and US could see further FX weakness for that reason. We are not in that world yet, but it is helpful to think about what happens if we go there. The second insight is that one interpretation of the Swiss National Bank’s decision to set a (depreciated) floor under EUR/CHF is that it follows one of the recommended paths for committing to a price level target to head off deflation risk. We think the commitment is credible, so EUR/CHF when close to the floor is effectively a one-sided currency. The SNB has also kept the option of re-pegging weaker wide open, particularly if deflation risk remains high. That too would be consistent with some of the recommendations for escaping a liquidity trap.


10    Stepping back, one striking feature of the broad asset picture is how rewarding it has been in general to be long a combination of both equities and bonds. US stocks are roughly flat on the year, but bond yields are much lower. The same was true last year. And since the market bottom in March 2009, equities have nearly doubled, while 10-year yields have fallen. On a day-to-day basis, the two assets remain firmly negatively correlated. But the negative trend in bond yields has been powerful and persistent, even with equities still much higher than a couple of years ago. While there is a tendency to see this as a “disconnect” between the two markets (with the general assumption from macro types that the bond market is “smarter”), we have shown before that this is in fact the “typical” outcome after housing busts, during stagnations, in sub-par recoveries and of course in periods when yields are aggressively targeted as a tool for easing. Any shift towards cyclical optimism should see yields move higher in the near term. But with sluggish growth likely to continue for some time, the message continues to be that long bond positions have remained a better hedge than you might expect for risk assets even with yields at historical lows.

It certainly seems like Goldman remains less sanguine than an exploding US equity market might suggest and we tend to agree that ignoring the fact that the EU Summit conclusions leave more questions than answers, it may allow us to focus once again on the fundamentals and those fundamentals are not a rosy as many would have us believe.