Kicking the Can Down the Road

A Second Dip of the Great Recession in the DM is Inevitable… but not just yet.

Whether or not we see a double-dip recession, or merely slump into a “growth recession” remains an open question; we would hedge our bearish outlook, given the near certainty of stimulus in the event of any meaningful weakening of the US economy or the European banking system.

Were it simply a matter of economic drivers, i.e. in the absence of central bank monetary gymnastics, we would consider a recession in the DM to be a near-certainty; while we certainly do not share the faith of some of our more “Austrian” peers in the healing qualities of an occasional economic meltdown, we do agree that both fiscal and monetary policy have their limitations. In any event, the question may be moot since public policy is increasingly the main near-term determinant of economic outcomes.

Since there is no fiscal rope left, and base rates can be cut no further (absolute boundary at zero), the DM central banks would be pressed to deploy overwhelming monetary firepower (quantitative easing) if threatened with outright deflation.

It should be stressed that this approach is experimental – it is by no means certain that the central banks would be successful in gaining traction. The danger is that, even in the short term, the monetary authorities could end up “pushing on a string,” i.e. pushing excess liquidity into a system where there is inadequate demand for credit, dangerously increasing the money supply without preventing a recessionary outcome; of course, the long-term consequences of a “successful” monetary stimulus program are a matter of conjecture, may lie outside of our relatively short event-horizon, and are quite possibly catastrophic.

4-Intermediate conclusion: on equities, we are “flat and worried” – the economic context suggests a sell off of >25%; successful quantitative easing would produce a rally at least as great. You pays your money and you takes your chances – we would be very selective, buying cashflows or remaining on the sidelines.

1. The Death of the Credit Bubble: Private Deleveraging, Public Assumption of Private Liabilities

For the past several decades economic growth in the West (especially in – but certainly not limited to – the United States and the Anglo-Saxon countries has been driven by continuous credit expansion, culminating in the explosive final salvo – the debt securitization bubble.

We would assign a zero percent probability to a resumption of rapid private credit growth; thus, even were the other imbalances in the global economy to be successfully addressed, what was perhaps the major growth engine will henceforth be missing.

The ability of governments to continue to borrow, replacing private entities, will be constrained by growing market/political concern over unsustainable public indebtedness. The public deleveraging has already begun in Europe – we doubt that the US can remain in denial very much longer.

2. Substantial Excess Capacity

Do not expect a new investment cycle. Companies are hording cash or returning it to shareholders. The latter are disenchanted with equities (pills, prayers and promises) and instead are demanding cashflows.

3. Fiscal Restriction starts about NOW

· US

Predictability is sharply constrained by political factors. The American political system is broken, probably beyond repair. There is no likelihood of any politician delivering a Cameron-style “blood, sweat and tears” program and surviving his next election. The willingness to accept pain is conspicuous for its absence.

The US is facing a mid-term election which will almost certainly leave the President facing a hostile legislature, leading to an exacerbation of the current political paralysis. While markets have seen several waves of panic over the fiscal crisis in Greece, in the global context Greece is a rounding error; the real threat is fiscal sustainability in the major industrialized countries – first and foremost the US. While there is a zero percent risk of outright default, given the fragility of the political system and a cultural inability to accept a recession, the ultimate monetization of debt seems the most likely outcome. How such monetization could play out, and indeed, whether it is possible at all in the context of modern globalized financial markets, remains an open question.

· Europe

Fiscal retrenchment is already underway in Europe, especially the UK and the PIIGS, but also in the major EU quartet. This should ultimately support the Euro, the death of which has been greatly exaggerated.

Furthermore, whilst fiscal policy has remained conspicuously tight in the majority of the Emergings, monetary policy is becoming increasingly widespread in the EM. A fundamental consequence of this is a shift in the traditional perception of risk towards a more favourable assessment of EM assets and currencies viz-a-viz those of the DM.

· Japan

“Hopeless” is the first word to come to mind. We have long held that Japan’s problems are literally insoluble, while cautioning against trying to trade this view; it will, of course, end badly – but this may well prove to be a problem for the next decade…

·            Emerging Universe

With a few noteworthy outliers, massive, unsustainable budget deficits – once the apanage of the emerging world – are now largely confined to the DM. Thus, the main emerging markets are edging towards monetary tightening, and mild, if any, fiscal restriction.

4. A Nervous Market, Favouring Fear over Greed

Ø   Dysfunctionality of financial markets

Ø   No more investors – we are all traders now!

Ø   Damage to the equity case by recent volatility

There has been an uncontrolled growth in the population of carnivores (financial players) at the expense of those at the bottom of the food chain (savers), seriously imperilling the fundamental sustainability of the ecosystem.

We cannot stress enough the complex but negative implications of the runaway growth in financial markets – increasingly self-referential and decoupled from the underlying economy (their only social justification.) This rise of “casino capitalism” has a number of investment implications:

·            Favouring fixed income and other cash-generating assets at the expense of equities

·            Favouring high-dividend paying stocks at the expense of growth stocks

·            Shifting relative risk perceptions towards EM assets, by discrediting DM markets

·            Sharply increases the risk of legislative/regulatory/political backlash in the DM. We have repeatedly warned of this risk, and believe that the current regulatory tightening is only a foretaste of that to come.

Ø   Demographic shifts towards fixed income Aging populations spend down their savings; they hold fewer equities and more bonds.

Ø   Too many guys trading the “greater fool” – e.g. Treasuries The Treasury markets are best described as an “accident going somewhere to happen.”

Despite the above discussion of economic weakness, NO ONE lends money to the US government for 10 years for an expected return of less than 2.5% before inflation (nor, a fortiori, for 30 years – for a few pennies more!). There are thus two main drivers – absence of compelling alternatives (fear trade) and the expectation of being able to trade out in time (greater fool theory).

We would tend to short the UST on a tactical basis each time yields hit new lows, however for now we would be cautious of holding short positions since yields could be driven down as low as 2% at some time in the next 12 months if economic releases continue to disappoint. On a fundamental basis, short Treasury seems a compelling trade.

5. Currency Parities will take much of the Strain

The autarkic growth of currency trading as a stand-alone profession has probably removed the last trace of rational market adjustment of currency rates; the problem is that momentum becomes hugely amplified in one direction or the other, while governments attempt to set currency parities to support their own economic policies – anti-inflation or pro- exports.

Long-term dollar bears, we are nevertheless cautious of market volatility; in the short term, it is clear that the dollar is very much part of the risk-on/risk-off trade, and at times of risk-off one wants to be long the dollar – and the fundamentals be damned. At present, market appears to be moving back into risk-on, so the dollar should be aggressively divested. That said, the belated intervention by the Bank of Japan to stop Yen appreciation has unleashed a cat amidst the pigeons.

Commodity currencies first surged, then sold off, then surged back, as traders attempt to assess the implications. In our view, the G7 currencies are unsustainably over-valued against the high-growth emergings, and at some point must correct. Our currency preferences remain unchanged – we are cautious Euro bulls; for speculative gains, we would trade the commodity currencies; for long-term value preservation, would own the Asian currencies, both emerging and developed.

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