Credit Suisse isn’t giving up on their bullish market call. In fact, they’re taking the opposite side of just about every opinion/position I currently maintain. They think the global economy will finish 2010 with a bang, equity markets will rally substantially, there is no threat of deflation, Europe is an overweight and that there is significant risk of a funding crisis in the USA.
– Macro: still pretty optimistic on global growth (4.5% in 2010).
– Markets: target 1,270 on the S&P. but we think there is a high probability of a significant equity market correction in H2 of next year
– Regions: overweight Continental Europe and o/w NJA. Underweight US
– Style: quality growth
– Sectors: marginal underweight of cyclicals. Probably at the margin, we would be more cautious on cyclicals. We focus on corporate spend sectors, much preferring corporate spend to consumer.
– Biggest/ most obvious macro theme for the next 1-2-5 yrs: closing of the gap between BRICs share of GDP (at 42%) and US consumer share of GDP.
Macro: Global PMI (which lead growth by about 6 months) consistent with about 4.5% global growth in the next 6 months. Yes, global lead indicators are just in the process of marginally rolling over, but only marginally so.
The 4 primary reasons why they remain positive on the economic outlook follow:
(1) Corporates are under-invested. FCF is at all time high, investment share of GDP at all time low levels, at the time when best leading indicators of capex (CEO business confidence, business investment intentions) are very strong.
(2) Employment: best lead indicators consistent with 250k non-farm payrolls each months over the next few months in the US. High probability that in the US corporates have over-shed labour (hours worked down 8% while GDP down 1.2%- huge discrepancy).
(3) US housing is stabilising. Affordability is highly attractive (with the house price-to-wage ratio at a 30-yr low. Housing is important as it accounts for 1/3 of household wealth
(4) China: 80% chance China will achieve a soft landing
(i) Recent China economic data beginning to roll-over- this is good news (as hard landing is caused by too little policy response too late and then too much too late). Looks like policy in China starting to work (hence slightly softer China macro data).
(ii) Degree of economic overheating in China? 4 out of 5 indicators we look at are less stretched than in 2007. One worrying indicator: we are a little more worried about labour market tightening in China than previously. A Survey by the Ministry of Human Resources and Social Security shows the labour market at its tightest since the survey began in 2001 (something that would be backed up by anecdotal data) and, moreover, Chinese export prices in RmB terms are now rising.
(iii) Investors might be exaggerating the impact of a 20-30% fall in China house prices on China growth. We think China can withstand that. The central government can afford to take on board local government debt as central government debt is only 20% of GDP and would rise to 52% of GDP if the central government took on ALL local government& UDIC debt.
(iv) Long-term China story does not end until they run out of labour (100m excess rural workers+), capital (huge FX reserves) or are overleveraged or over-infrastructured. None is a problem.
Unfortunately, their analyst team shows a weak hand when they disclose that they are terrified of a funding crisis in the USA. As regular readers know this is nothing short of absurd and displays, in my opinion, a gross oversight with regards to the way our monetary system functions.
Big issue is when do we get a global government bond funding crisis? Currently US banks hold 13% of their assets in govt securities and this could rise to 20-25% over the next 18 months (due to liquidity/ regulatory requirements and bank loan growth being depressed). We think we will not get a global govt funding crisis until 2 things happen: (1) banks have a high % of their assets in govt bonds, (2) most importantly, loan growth recovers (and banks lend to corporates and household sector, not the govt). This will not occur until H2 2011 or even considerably later.
Just to stabilise government debt-to-GDP the US, UK, Japan need to tighten fiscal policy by 7-8% of GDP (assuming a normal economic recovery). We think events could develop like this:
Stage 1: govt bond yields could stay much lower than people expect and for much longer than expected
Stage 2: H2 2011. Bond yields rise sharply as bank loan recovers, prompting fiscal tightening (which threatens economic downturn. Equities could correct sharply, into that major CBs ( BoE, ECB, BoJ, Fed) renew QE to drive down bond yields.
On the inflation/deflation debate they see no risk of deflation:
Deflation debate: we do not believe that the global economy will enter deflation as: (i) deflation requires falling wages (which account for 70% of inflation) – yet, wage growth is still positive in almost all major developed regions and also inflation expectations are still c 2% in the US and Europe). (ii) No deflation in emerging markets (c 50% of global GDP). Indeed, GEM wage growth and core inflation are rising. (iii) M3 is falling but it lags the economy by a year, while M1 tends to lead growth and is still rising at 7% yoy in the US (consistent with 4% GDP growth). (iv) Bulk of bank de-leveraging has occurred; (v) deflation historically has been the result of policy mistakes.
Conclusion? Remain bullish:
Equity Market view: we are overweight equities
(1) 80% of the time equity market corrected as much as it has, we had a hard landing, yet double dips are extremely rare (and only happened twice in the last 100 years).
(2) Margins are high but ROE is only at average levels due to asset turns and leverage still being low. Our margin proxy supports high margins (labour does not get pricing power until US unemployment falls below 7%).
(3) EPS forecasts: we forecast 35% eps growth in the US and 26% in Europe in 2010. but what is priced into he market in terms of eps estimates? Dividend futures price in c 10-20% fall in EPS in Cont Europe. Valuations of equities are broadly neutral (may be slightly above average) but not extended.
(4) Credit now appears to offer some value (plus last time CDX spread was at this level, s&p 500 was at 1,300).
(5) Encouragingly we find that investors are still positioned relatively conservatively.
(6) One of our tactical indicators (% nyse stocks above 10-week ma) gave us a buy signal at the end of May. Others came close.
How to play it?
(1) Overweight Cont Europe (esp Germany). As above
(2) Focus on corporate spend related areas (tech, advertising)
(3) Consumer staples with emerging markets exposure
(4) European Telecoms
(5) Quality growth stocks
(6) Regulated utilities with a CPI link (index-linked proxies)
(7) Stocks that look “safer than governments” (i.e. have CDS spread below their government CDS and DY above their govt bond yield).
Mr. Roche is the Founder and Chief Investment Officer of Discipline Funds.Discipline Funds is a low fee financial advisory firm with a focus on helping people be more disciplined with their finances.
He is also the author of Pragmatic Capitalism: What Every Investor Needs to Understand About Money and Finance, Understanding the Modern Monetary System and Understanding Modern Portfolio Construction.