Downunder Daily : The Debate Continues
I published an internal e-mail debate just as
the rally was starting (Downunder Daily: What Gives? 20 March). Here's
another installment:
Jerry Lou: Liquidity globally is likely to remain ample, China
remains accommodative on fiscal and monetary policies too. Although these
policies may push the global economy towards further imbalance, they do feed
asset prices and risk appetite. Are we seeing a mini-asset-economy boom-bust
cycle develop?
Of course, inflation hedges can force up
energy and commodity prices quickly and China will be sucking in inflation in
sooner than later (Exhibit 1). But if inflation is a 2010/2011 risk, asset
prices could inflate for another 6-12 months before they force regulators to tighten
and destroy risk chasing capital. Is this a fair assessment? If so how much
more upside we could see in energy/commodities/equities/properties (Exhibit 2)?
I'm still convinced that this will end in
tears but is there a way to make money for clients in the interim?
Teun Draaisma: Jerry, that view is now quite popular among hedge
funds in London. It is a continuation of Joachim's call which has been working
so well this year. I think it is quite possible. We are keeping an open mind.
On balance, however, I would not count on it because the main obstacles are the
following:
1. Valuations already above fair value (part
of the bullish view is that this does not matter);
2. Earnings to come down further (part of the
bullish view is that people fully expect this);
3. Unemployment will rise further/US house
prices will fall (the bullish view thinks that these are lagging indicators);
4. Banks' balance sheets may have been
stabilized but are not in a position to expand (the bullish view thinks that
there are other transmission mechanisms such as liquidity and equity prices);
and
5. The second derivative may have improved
but is still awful. We know recessions involving banking and property crises
take longer and recessions have the habit of throwing up unexpected pain in
unexpected places.
The bullish view is not crazy, but it is not
what we currently expect. New lows this year unlikely I suppose, with the world
having been saved, but we are not chasing the rally.
Jerry Lou: That's why asset economies (or liquidity economies
right now) do not last. When capital runs out of choices it means, from a macro
perspective, asset prices are moving too far off the fundamentals. It signals
that the liquidity flow can't sustain markets, and the head-fake economic
prosperity derived from it is about to stop. The end for this scenario is
capital destruction, not capital "going somewhere" - we have seen it
in 1998, 2001 and 2008, in my humble opinion, and I have no uncertainty about
how it ends.
The big question now is how long can this
mini-asset-economy- cycle, if we are calling one, last before it ends? Although
I don't know how to model it, for someone who might do, the inputs have to
include, in think: 1) liquidity potential; 2) asset price responses and economy
responses consequently (consumers in US and developers in China, for example);
3) policy tolerance within the cycle and potential policy responses at
different stage.
Jason Todd: Agree that Jerry's liquidity argument is quite a
widely held view amongst the US client base as well.
There is a real possibility that this occurs.
The consensus may also be right on 2010 - which could end up being stronger
than I expect on the earnings front - but it gets 2011 wrong, where there is an
exponential extrapolation of improvement in order to get back to (above) trend.
The risk of higher oil, fading of stimulus, sub trend GDP growth, higher
bond/borrowing rates, weaker improvement in margins and return-on-equity could
all undermine 2011 profits relative to expectations.
We have said for a while that we thought the
lows were in, but I don't believe valuations or the prospect of earning
downgrades are yet strong enough head winds to cause a major correction unless
the data get significantly worse than consensus. The valuation rubber band
isn't stretched enough on the upside in my view and the near term earnings risk
is now back to what is a 'normal' sized cycle adjustment (market can probably
suck up 10% downside).
On the banks, Betsy Graseck points out that
the market's earning assumptions could be too pessimistic implying capital
requirements that are likewise too pessimistic. That doesn't mean they expand
their balance sheets aggressively but it could provide a larger near term
cushion (or give the market greater comfort).
Ted Wieseman: Add massive tax hikes in the US to the downside to
2011. That, combined with an expected real rate shock as quantitative easing
ends, layered on an economy not showing much of a recovery to begin with, and
base case US outlook for 2011 is probably at least a mild recession at this
early point.
Richard Berner: Agree with Jason that the more upbeat view is now
widely held in the US. The evaporation of systemic risk leaves us to worry
merely about cyclical risks. And with markets increasingly open to finance the
previously-presumed dead (Exhibit 3 shows corporate debt issuance), the
perception of those cyclical risks is that they are today's news, not
tomorrow's.
As further evidence, clients are increasingly
looking for ways to play the rally FX, especially paired with commodities. Long
commodities/short USD is growing in popularity. For the first time in two
years, clients are starting to ask about longer time horizons, sustainable
growth rates, exit strategies for monetary policy.
Three factors keep me in the play-the-rally
camp:
1. The improvement in financing markets can
go further, muting the cyclical pressure on consumers and businesses.
2. Companies are starting to take out
capacity, which will be good news for earnings.
3. And clients are for now willing to buy on
dips again -- they don't see this as just a bear market rally.
But I still think the factors arguing for a
slow and painful recovery are still in place, and that they matter. For more on
that, see my latest note: US Economics: Handicapping Recovery Upside, 18
May.
Joachim Fels: I think the big question is where will all the
liquidity go that central banks are still pushing into the system? The Fed is
only about a third through its quantitative easing (QE) program, same for Bank
of England, and the ECB hasn't even started covered bonds and will soon give
banks 1-year unlimited financing at 1%. Excess money measures are now
accelerating (Exhibit 4).
I understand all the fundamental arguments
for why this is only a bear market rally and share the view on earnings, slow
recovery etc. But I think it could simply be swamped by the 'wall of money'.
(For updates on central banks' actions, see the weekly Global Monetary
Analyst.)
Alexander Kinmont: From a Japanese perspective, what turned bona
fide rallies into failed bear market rallies was that policy was tightened.
I don't see how one can take largely theological positions in respect of
whether this is a 'bear market rally' or something else unless one has a view
on the 'exit strategy' from current policies. At a practical level, Japan's
experience suggests that the right thing to do is to run with the market while
policy is loose. At any sign, however apparently trivial, of tighter policy one
runs for the hills.
Gerard Minack: We may soon - within a month or two - be able to
settle this debate. Colleague Bill Smith has a number of indicators suggesting
that positions have normalized. Exhibit 5, for example, shows the performance
of an ETF that tracks large-cap core mutual funds in the US, relative to the
S&P500. The recent out-performance of the ETF suggests that it is no longer
the 'pain trade' for equities to go higher.
My own sense is that this repositioning -
accompanied by improving fundamentals (largely the downside tail risks
shrinking) - are the key drivers of the rally. We know bear-market rallies go
hand-in-hand with market bear markets. (Although as I agree with Teun and Jason
that new lows are no longer a base case scenario, perhaps we need to change the
nomenclature.)
Because markets over-shoot, and because ample
liquidity may be playing a supporting role, going defensive now may still not
be the best risk-reward trade. However, as markets move higher the risk-reward
starts to tip. I've pointed to a range of 950-1000 on the S&P500, with
1,100 at a stretch, as where the risk-reward tips to turning defensive. My view
is that we will then see a tradable retracement. If Joachim's right, however,
I'll be wrong.
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