Pragmatic Capitalism

Practical Views on Money, Finance & Life


As we mentioned on Friday, the cards may be stacked against equities in 2010.  After a spectacular year and one of the greatest rallies in the history of the equity markets stocks are now arguably overbought, overvalued and on borrowed timeLike Morgan Stanley, Credit Suisse strategists believe 2010 will be a difficult year for equities.

In terms of their macro 2010 outlook CS sees 4.1% global GDP (3.3% in the U.S.) and muted inflation.  They are quite positive about the first half of 2010, however.  They target 1220 on the S&P by mid-year and 5750 on the FTSE.  However, CS is increasingly concerned about a government funding crisis that eliminates all market gains in H2 of 2010 and sends markets reeling again as the problem of debt once again rears its ugly head.

CS is positive on global growth for 5 primary reasons:

1. Employment to turn positive in Q1 in the US- corporates have overshed labour, especially in the US;
2. Corporate spending to pick up
3. China to grow strongly (10-11%) and not tighten aggressively until there is “economic overheating” (as opposed to “financial overheating”), ie not until there is an acceleration in wage growth (2011);
4.  US housing continue to recover (house price-to-wage ratio close to a 40-year low);
5.  The inventory rebuild is yet to occur.
On the inflation front, CS sees very benign inflation in 2010 for reasons we have detailed thoroughly here at TPC.  They do, however, see a very high risk of inflation in 2012:
(a) wage growth in the US, UK and Japan close to 50-year lows (and wages account for 70% of inflation);
(b) output gaps suggest inflation will fall;
(c) China is exporting deflation;
(d) owner-occupied rents (which are 40% of US core CPI) are likely to fall (given that they lag house prices by two years). We believe significant inflation risks emerge from 2012 onwards.
CS is not at all worried about the Fed raising rates soon.  They see the Fed raising in late 2010:

The Fed will be slow to raise rates (unlikely to hike until late 2010). Normally, the first Fed rate hike is 19 months after the peak in unemployment.
De-leveraging will continue to be a drag on the economy and the savings rate will remain higher than normal:

Consumer to de-lever slowly as rates remain on hold.
There is still $2tr of excess US consumer leverage. If asset prices rise and rates stay low, the US consumer is likely to take the slow de-leveraging route (with the savings ratio staying around 5%).
As regular readers know, the biggest threat to the economy will actually come from the supposed solution: more debt.  Ultimately CS sees the problem of debt causing major government funding problems:

(5) Government debt is the biggest threat: government debt does not become an issue until there is a recovery in private sector credit growth (unlikely until late 2010/11). Until then, banks fund the majority of budget deficit, keeping bond yields low. Once private sector credit demand returns, banks should find it more profitable to lend to corporates and consumers (rather than buy low yielding govies) and then bond yields are likely to rise sharply (as they did in 1993/4). The response to this is likely to be fiscal tightening (4% of GDP) and more QE (to cap real bond yields).
So how does CS see all of this playing out over the coming few years and how do you benefit from it?   They see the next major leg down in economic growth occurring in late 2010 or 2011.  The likely catalysts for the downturn will be one or all of the following:

(a) A government bond funding crisis (late 2010 or 2011) as private sector credit growth returns
(b) Accelerating Chinese wage growth (unlikely until 2011).
Until Q3 2010 they see robust economic growth, accommodative policy, banks funding government deficits and low inflation continuing to favor equities.

Sometime in late 2010 or early/mid 2011 they see the Fed raising rates.  In addition, bank loan growth is estimated to return leading to a reduction in bank bond buying.  Bond yields spike and the Fed is forced to respond with easy monetary policy.  Making matters worse is Chinese central bank tightening after wage growth begins to expand sharply.

In H2 2011 or 2012 monetary and fiscal tightening will lead to another recession.  Chinese growth slows. Another sharp downturn ensues that finally sets the table for a long-term sustainable bull market.

In the very near-term CS remains quite positive on equities for the following reasons:

(1) Better growth/inflation trade-off than expected;
(2) 25-30% earnings growth (falling ULC, outsourcing= strong margins, revenue estimates seem 2-3% points too low);
(3) Major credit and macro variables at levels when the S&P 500 was 1280.
(4) Valuation neutral.
(5) Investors are still sceptically positioned money market funds still have above average cash levels, retail have bought far more bonds than equities and institutions appear to be underweight equities.
(6) Excess liquidity remains extreme.
Where to invest?  The UK, Japan and US are all underweights as high debt levels and low growth make them less attractive regions.  Asia ex-Japan remains overweight while continental Europe also remains overweight.
Cullen Roche

Cullen Roche

Mr. Roche is the Founder of Orcam Financial Group, LLC.Orcam is a financial services firm offering asset management, private advisory, institutional consulting and educational services.He is also the author of Pragmatic Capitalism: What Every Investor Needs to Understand About Money and Finance and Understanding the Modern Monetary System.
Cullen Roche

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