Downunder Daily : The Year Ends, Not With a Bang, but With a Whimper
year with a table-banging list of high-conviction views on 2009. I
can't. Here, instead, are some thoughts:
1. The Fed will win,
ultimately. This week's FOMC statement underscored what has been apparent for
some time: There are no rules, there are no limits, on what the Fed will
consider. It will put Federal Reserve ATMs on every street corner, if required.
That is why at some point the cycle will turn, and there will not be another
Great Depression. Of course, you don't need a Great Depression economic outcome
(25% unemployment) to get a Great Depression market outcome (80%-plus price
declines).
2. The key issue for investors, however, is not
whether the Fed wins, but when it wins. That is, at what stage has
the Fed done enough to put a floor under the real economy? Investors ask this
question in every cycle: They don't buy risk assets on the first Fed rate cut,
but only when they get a sense that the Fed has done enough so that markets can
price in a cycle recovery.
3. Judging when the
Fed has done enough to put a floor under the cycle is unusually difficult in
this cycle, for two reasons. First, the cycle seems set to be very deep, and the
risks slanted to the downside. Some leading indicators are off the charts.
Exhibit 1, for example, shows the ECRI's leading index. Second, the Fed is
responding with unconventional policy tools. We - investors and policy-makers -
have long experience with conventional policy tools; we have little or no
experience to guide us on how effective the measures already taken, and in
prospect, will be.
4. It's become a cliche, but
it's true: This cycle started with credit, and it won't be over until credit is
healing. Consequently, money supply isn't the main game - it's credit flows
(Exhibit 2). Some credit markets are improving, but many remain broken (Exhibit
3).
5. The US cannot do it alone. If healing credit
markets is the first precondition for a cycle bottom, my second precondition is
that non-US policy makers do enough to ensure that their economies have
troughed.
6. Just as credit markets haven't yet healed, I don't think
policy-makers outside the US have done enough. Non-G7 policy rates only recently
started to decline (Exhibit 4). The thornier issue is this: If, as is the case
in the US, non-conventional policy is required, will policy-makers outside the
US do what is needed to put a floor under growth in 2009? ECB ATMs? I can't see
that anytime soon.
7. Everyone's concerned
about 'flation. Many are worried about deflation, and almost as many about
inflation. Market pricing implies more are worried about deflation (Exhibit 5).
A year ago, I said I didn't have an inflationary bone in my body; now I likewise
struggle to worry about deflation. In fact, if you agree with me that at some
stage the Fed will win, then deflation - sustained, broad-based price declines -
will not happen, at least not in the US.
8. I
think the period of maximum risk for the US$ (and Treasuries) is when the cycle
has passed an inflection point, not now, when investors have little clarity on
the depth of the downturn. This is Stephen Jen's dollar-smile story: The dollar
is now the tallest pygmy in FX markets (Dick Berner's line, not mine).
9. Every great bear market - 50%-plus, multi-quarter market declines -
has significant bear-market rallies. What's a 'significant' bear-market rally?
One that hurts the bears. Short-lived 20-30% price pops don't count; real
bear-market rallies worry investors that they may have missed the bottom, and go
on long enough that they hurt the laggards (that is, gets reflected in
performance figures). We haven't seen one of these yet, but I expect we will.
10. My sense is that most investors still don't trust risk markets, and
would not be convinced that any near-term rally will be sustainable. Many expect
the final lows around mid-year, with a sustained rally commencing through the
second half. Consequently, if you want to be contrarian, expect a big rally
through the first half year of 2009, before markets fall back to - or through -
their lows in the second half. That, by the way, is not a table-banging
forecast.
That's it from me for 2008. Thanks for the brickbats and
bouquets this year. I'm off to the beach, and will be back 19 January. Enjoy the
break. Cheers, Gerard
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END OF RESEARCH ABSTRACT
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