Excellent reading here from one of the great investors of our time:
As put forward in our last correspondence of late April, global growth performance is turning out to be better than markets and the consensus expected just a few short months ago. The large negative overshooting in economic activity over the turn of the year is now poised to be reversed in a V-shape type of recovery—although with such V stabilizing below pre-crisis levels of trend growth—led by an inventory rebound and the impact of the massive stimulus implemented by global policy makers.
Policy initiatives targeted at eliminating tail risks have successfully reduced risk aversion and risky assets have rallied almost across the board, reversing some of the large wealth losses suffered by global consumers. To be sure, many doubts remain about the sustainability of this recovery, most prominently the weakness of household income growth, and the damage inflicted by the crisis to potential growth in many countries will likely deliver a recovery that will look subdued by the standards of the past decade.
High and persistent levels of unemployment in an environment of very large fiscal deficits will greatly complicate policy making. In fact, as tail risk has diminished significantly, policy makers have started to focus on exit strategies, with sometimes premature and excessive impetus. The lack of understanding by both markets and policy makers of the impact of the mix of large fiscal deficits and quantitative easing policies has increased volatility and generated fears of uncontrolled inflation. In addition, fears of debt monetization have sharply increased central banks’ caution with quantitative easing actions. As a result, despite having some further room to ease, the main central banks have moved into a wait-and-see stance. The Fed is very unlikely to increase its purchases of Treasuries, though it will likely keep rates on hold at 0.25 percent until at least the summer of 2010. The ECB will very likely keep policy rates at 1 percent for a long time while allowing money market rates to remain lower with the effect of engineering looser financial conditions for as long as needed. The BoJ has successfully implemented many credit market initiatives, but is unlikely to increase its Rinban purchases despite surging JGB supply. The complex combination of decelerating inflation, very low short-term rates, rising fiscal deficits, and marginally hawkish central banks will pose a challenge for fixed income markets, as we discuss below.
Overall, the period of fiscal and monetary polices pushing in the same direction is over, and policy makers are starting to weigh the costs and benefits of erring on the side of caution. Even the Chinese authorities are starting to show some policy restraint, after two quarters of very rapid credit growth. Some critical initiatives, mostly related to financial sector restructuring, have been cut short as polls show negative voter sentiment toward active government intervention. As a result, toxic assets remain on balance sheets and credit growth will likely be subdued for a long period of time. Policy stimulus will peak around Q1 2010, and many liquidity facilities and credit guarantees will likely be discontinued around that time; at that point, markets will have to assess the sustainability of growth. Despite the current inflation fear, a deflation scare—driven by the medley of low core inflation, high output gaps, high unemployment rates and very weak wage growth—can’t be ruled out in 2010. But, until then, the return of positive rates of economic growth will likely sustain stock prices and generate a constructive environment for risky assets.
The unprecedented financial crisis we have witnessed in the last 12 months has lead to equally unusual fiscal and policy measures. The authorities’ response to the crisis was broad in scope and large in magnitude, such outsized measures aimed at slaying the debt deflation monster perceived to be lurking in the background. We are now pretty much in uncharted territory, since the precedents for these policy responses are very few and far between (especially for industrialized countries). As a result, the implications of these policy measures for inflation, real interest rates and the shape of the yield curve are particularly challenging.
Looking hard for guideposts to help us navigate the fixed income markets, we are focusing on three key themes, namely: the potential inflationary consequences of the explosive growth of the monetary base; the lingering deficit implications of expansionary fiscal policies; and the dampening effect of credit contraction on growth prospects. The inflationary risk would materialize if the seemingly bottomless demand for money became satiated and began to decline. If the monetary authorities were perceived not to be sufficiently quick to drain the excess liquidity in the system, the spillover effect on prices could be substantial. Fixed income markets would come under pressure, in this scenario, as investors would demand an inflation premium to hold nominal assets.
In a similar vein, the fiscal expansions engineered in most regions of the world to counter the drop in private sector demand has left a trail of funding requirements that will stay with us for several years. The resulting supply of government bonds is on the rise globally, and investors may demand a price concession (i.e. higher yields) in order to absorb it.
These bearish fixed income risks, however, could well be swamped by weak consumer spending, a relapse in investment activity (post-inventory re-build) and weak external demand facing the major industrialized countries. This scenario could be underpinned by the reluctance on the part of financial institutions to extend credit, the desire on the part of consumer and businesses to repair their balance sheets, and the protectionist tendencies that emerge internationally during periods of financial strain. The resulting increase in savings, and potential widening output gap, could well offset the negative forces mentioned earlier and lead investors to seek refuge in fixed income assets.
We would expect these opposing forces to ebb and flow over the next few months, as market participants, as well as policy makers, read the tea leaves of economic data as they emerge in the aftermath of this very unusual period. Bond markets will react accordingly, but probably remain range-bound between now and the rest of the year. Excessive rate moves in either direction will raise increasingly greater doubts about their sustainability, given the mixed signals we expect going forward. The trend, for now, need not be a friend. A resolution of this impasse may not come for several months, and until then, our positions in fixed income markets will be more tactical than strategic.
Last quarter saw market participants embrace risk assets, thus lifting commodity linked currencies and broadly weighing on the US dollar. The path ahead for the US dollar will hinge on reserve accumulation and diversification by surplus countries. As global trade and risk allocations recover, reserve accumulation will prompt diversification into euros, pounds and, to a lesser extent, yen and the Australian and Canadian dollars. Reserve accumulation and diversification trends will be persistent and mutually reinforcing with the direction of the US dollar. The weaker the US dollar the more likely reserve managers are to diversify into the above currencies. The US dollar will have bouts of strength that will surprise markets—for example, the US dollar typically is supported at the close of economic recessions—but it should nonetheless end the year lower than now and the correlation between risk assets and currencies will remain high.
A key question for the Australian dollar, as well as for other commodity currencies, is, “How long will China add raw materials and can usage keep pace with inventory?” China went on a commodity spending spree during the first half of the year as it built inventories and bought controlling interests in mining and other resource corporations. We expect there to be little let-up in Chinese stimulus through year-end which will keep the currency bid. The RBA has been very effective easing financial conditions and likely will be the first G10 bank to shift to a hiking bias, which is also supportive of the Australian currency, in addition to a current strong M&A pipeline.
Yen strength versus the US dollar has surprised many market participants. The cross will continue to present two-way risk. Further yen gains will depend on Japan’s return to trade surplus, corporate earnings repatriation under the Japan HIA tax provision and foreign buying of Japanese equities. Yen depreciation pressures will depend on Japanese domestic demand for high yielding FX denominated investment vehicles. The Japanese domestic sector has been slow to embrace a risk seeking environment but we believe that Q4 may see an increase in these outflows.
Emerging market commodity currencies with solid public sector balance sheets will continue to appreciate over the medium-term.
At a gain of over 45% in less than 100 trading days we ask, “Is this a new bull market, or only a bear market rally?” The question is largely irrelevant from a trader’s perspective but we will offer a view: bear market rally. Back at the lows there had been such a large risk premium built into equities, along with a concomitantly large short/underweight position, that when the extreme tail risks were avoided, a rally for the ages resulted. As we previously have written, however, impressive counter-trend rallies are a feature, not an oddity, of secular bear markets. It is tempting to get overly influenced by the percentage change metric, but all moves must be taken in the context of the broader volatility regime within which they occur. Stating the obvious, the last year has been a period of record volatility. While 45% is nothing to ignore, one should take into account that the S&P through July 31 is still down more than 20% on a price basis year-over-year. The bottom line is that we are not inclined to aggressively chase the market here. Rather, we eye a better opportunity to be long equities into year-end on a potential autumnal pullback.
As outlined above, the macro risks are becoming increasingly two-sided. After a period where fiscal and monetary policies neatly aligned globally, they will start to become discordant. While there is no expectation that any central bank of note will actually raise rates this year or perhaps even early next, the fact that “exit strategy” has entered the lexicon is probably worth an incremental notch higher in the risk premium. We are certainly not alone in remembering the catastrophic misstep by the Bank of Japan when its officials attempted to raise rates in August 2000. The ECB last summer serves as more recent reminder of how equity markets treat policy mistakes—none too kindly. Sentiment toward the asset class is improving by the day but it would be a mistake to confuse momentum for resolve. Investor psyche is still fragile. The inevitable slowing of China (the second derivative argument cuts both ways), and the return of swine flu headlines as a front-page topic are further catalysts for global equity markets to pause in September.
Regionally, we are intrigued by Japan. It appears to be the developed equity market in which investors remain the most underweight, and we believe the upcoming Lower House election, which should lead to the LDP losing control for one of the few times in the last 54 years, likely will lead to a considerable closing of this underweight positioning between now and year-end. We are also willing to retain some long beta exposure via emerging markets. Europe and the UK offer more at the moment to distinguish themselves positively from the S&P but come with greater risk from new equity capital raisings, particularly in Europe.
In summary, as impressive as recent price action has been, we do not see the current reward/risk profile for new longs here as compelling. Macro risks are an underpriced consideration and seasonal influences should combine to weigh on the market near-term. Once these play out by mid-fall, the stage should be set for another run of meaningful size into year-end. We will seek our entry point to participate in such rally as autumn unfolds. Ultimately, however, we likely will find even such year-end upswing to have been yet another bear market rally, with markets retracing next year.
Source: Tudor Investment Corp.
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