Random Shots – 2011 Musings Edition

by Claus Vistesen

(work in progress, but I thought that I would publish it thus far, stay tuned for more additions)

I did have some plans to do a series of post to give a brief overview of my main macro and trade themes for 2011, but time has, not surprisingly, caught up with me. As such, you will have to make due with a special version of random shots.

Risky Assets to fly in 2011? – This one is a bit too general to answer in full of course, but one interesting discourse that has emerged lately is that, as bond vigilantes are feasting on the Eurozone (and even going for an altogether larger prey in the US), investors are being pushed into equities.

Following a well worn cliché in the world of finance, equities are the least ugly alternative.

Now, this may only be a working explanation on the surface since the underlying move into equities is also more part of the structural consequence of QE2 – since the Fed is not only trying to move investors around on the yield curve, they are also trying to move them out of the curve altogether and into more risky alternatives. In this sense, what appears to be a melt-up in equities might just be a slow but steady excess liquidity driven grind. Surely, Bernanke is in no rush to raise interest rates in 2011 and if the US economy continues to slowly heal, there will be only speed bumps ahead of a general trend upwards. One interesting thing here will be how the market reacts to even the slightest hawkish tone from the Fed or perhaps even a toning down of the dovish stance. I think they will not act all too well, but precisely because of this assumption (which I think many share with me), the Fed will remain uber dovish as far ahead as the eye can see.

Technically, I think the melt up towards the end year is in for a rude stop in the beginning of the year and I have the S&P500 declining to about 1180-1190 in January. This would then provide a potentially tasty entry point for a 2011 rally. Other than a veritable cataclysm in the Eurozone (which appears the main source of systemic risk at the moment) and China suddenly slamming on the breaks in an unduly harsh manner, I see little resistance for risky assets in 2011. This is especially the case as the BOJ and the ECB will likely add their interpretation of "QE2" to the table to respond to the on-going sluggishness of their respective economies.

We have already gotten a barrage of 2011 predictions and outlooks from research houses, banks and other financial sages and, quite frankly, it is quite difficult to get a bearing on it all. I did find the Barclays Macro survey quite interesting though, as it shows that about 70% of all investors see risky assets in the form of commodities and equities outperforming in 2011, while US treasuries will underperform. The underlying rationale is again quite simple, I think. Given the severity of the crisis, monetary policy will tend to apply the brakes with a considerable lag; and if 2010 saw the first signs of the effect of such a lag, 2011 could give us the full force. Again, this is especially important to note, as the ECB and the BOJ might just be about to join the party.

On the other hand, "underperforming treasuries" will also present Bernanke with a dilemma in the sense that, to the extent which the infamous bond vigilantes fancy more than a pot shot on US bonds, he may be forced to apply even more pressure to keep yields low.

Low Growth in the OECD – This one is hardly news and hardly one exclusively for 2011 either. However, I still think there is a lack of recognition of just how low growth in the OECD is likely to come in for the coming years. In this way, and just as investors have their focus set on outperformance in Asia and Latin America, I think that the ultimate growth outcome in the OECD will be worse than the market currently expects.

The point I am basically getting at is that we need to think about the fact that the Eurozone periphery essentially is going to be hampered by negative trend growth rates and that the rest of the OECD will be dependent on exports to grow (think mainly Germany, Japan and now also the US). Apart from any productivity miracle or some other exogenous source of growth, the growth engines in the OECD are simply stalled out. Indeed, this is probably the most important structural macro theme for me at the moment.

Now, as for 2011, a lot of this will also depend on whether economies really intend to walk the walk in terms of fiscal tightening or whether they are simply talking. Clearly, countries under the spotlight in the form of the Eurozone periphery will see their growth rates severely dented by the need to consolidate public finances. In the US, on the other hand, I think the latest estimate for the 2011 budget deficit is 10% of GDP, which is hardly tight.

According to the IMF’s latest forecasts, "Advanced Economies" will be running a deficit on a structural basis to the tune of 5% in 2011, and the G7 as a whole one of 5.88%.

But all this only goes to exacerbate the issue, since if there is one thing we have learned by now it is that one cannot borrow ad infinitum – and especially not as you are essentially borrowing against a depreciating asset in the form of future growth held down by an aging population. So the big (as in biig!) question is: if you subtract the 5% government spending-induced deficit from the equation, what kind of trend growth rate is left in the OECD as a whole?

Clearly, we know that some economies are now basically saddled with negative trend growth rates, but I think that even the aggregate number in advanced economies would be scary reading. We could call this decoupling in reverse. Thus, we are now vulnerable to the continuing growth spurt of Asia and other so called emerging economies. But in the end, it is a basic question of not having any more components of the national accounting identity to lever up, as it is abundantly clear that governments are only going to find it increasingly difficult to borrow (even in the case of very generous central banks).

Indeed, as we move forward, I see this low growth environment for the OECD (and actual negative trend growth in some economies) as one of the main components in my call that we are going to see some spectacular and costly sovereign defaults in the OECD edifice going forward. On this, I think the current mess in the Eurozone is only the beginning.

The Euro and the Eurozone – Actually, I have not followed FX a lot lately so I am a bit of out form here, but I still use my Old Maid metaphor when thinking about big global currency movements and intra G3 movements especially. Interestingly, 2010 saw JPY as a looser and thus holder of Old Maid in the sense that it appreciated significantly against the USD and Euro. In essence, the USD was being held down by the Fed’s policies and the Euro actually acted as a nice buffer against the crisis in the Eurozone as it fell strongly throughout the spurts of Eurozone tension in turn providing a much needed boost to external competitiveness when it was needed the most.

In principal, these trends do not stop at year end and will continue to dominate at least part of the intra G3 movements in 2011. The main question is what kind of bazooka, if any, the BOJ will pull out to revive the ailing Japanese economy. If it becomes the kind of shock and awe many are expecting we could be into a nasty long squeeze in the JPY. This also goes for the Euro in the context of the ECB being forced, kicking and screaming, into supporting Eurozone bond markets. I hold this to be almost a given since the current setup simply does not work.

Today, Trichet called for more bold action on the fiscal front and in terms of capitalising the stability front (didn’t he just tell them to tighten their belts?). This is no doubt part of a futile attempt to pre-empt any de-facto query, to the ECB, by part of the EU on taking an active and open role in the bailout. Trichet and his compadres are not going to like it, but the alternative of asking Italy and Greece to pay for the bailout of Spain, who in turn helped finance Greece and Ireland, is simply hogwash.

As I have noted on several occasions, should the issue turn out to be contained with Greece, Ireland and Portugal, the fiscal solution/stability fund would suffice, but evidently we are looking at a much more structurally problematic issue and Spain is surely next in line and even yields on German and Belgian bonds have begun to break loose. As such, it is becoming increasingly clear that the ECB will have to take a more active part beyond "simply" supplying liquidity to the banking system and buying bonds on the drip (or covertly).

I tend to have little opinion on the EUR/USD in general, but I will timidly forward the idea that we can expect the ECB to surprise with some open support to the periphery, it should provide some pressure on the single currency. Yet, it is also fair to assume that the extent to which risky assets soak in a bath of excess liquidity, the USD will depreciate and the Eurozone will gain on carry flows as interest rates are still higher in the Eurozone (especially, if things get so calm that the ECB starts turning hawkish again, but this may be self-defeating in itself, of course).

Emerging Markets – Well, the EM story is important enough to merit its own section even if it is intimately tied to the risky asset story. Yet, there is no need to re-invent the wheel and in this sense I think that Morgan Stanley’s Manoj Pradhan’s recent note on the 2011 EM outlook is pretty much accurate in all the important areas.

Especially his first point on structural outperformance by the EM relative to the developed world is important. Whereas 2011 should see EM growth cooling and, hopefully, growth in the developed world nudging up. As such, 2011 will see relative outperformance by developed markets. This is a bold, but also an astute, call. It is bold because I think the link between the EM and DM is still too strong to see DM growth decouple entirely for a relative slowdown in emerging markets. In this sense, how far and how fast monetary policy in emerging markets are tightened in response to fears of overheating will be key. It is astute because, all things point in the direction of a slowdown in the emerging world after a breakneck 2009 and 2010 and in this sense, on the margin, perhaps the developed world is the place to be in 2011 on a tactical basis.

I also like that he spends some time on the inevitable, but important, process of rebalancing away from a reliance of an over-levered Anglo-Saxon consumer in the OECD (and of course, a now cracked Eurozone periphery). Reverse decoupling and rebalancing towards the emerging markets are two of the main global discourses and real economic drivers at the moment.

Finally, I think it is also important to re-emphasize the basic problems emerging markets face as they try to cool their economies through higher interest rates only to allow more hot money flowing in. The policy mixture is obviously being developed as we move along with some form of capital controls being implemented across the board. In a world of structural excess liquidity this policy dilemma becomes an additional issue on top of the more traditionally discussed trilemma.

As such, I am largely cautious on the emerging markets going into 2011 as I think they are over-loved, but the long term bull call stands uncontested. In addition, there appears to be general acceptance and expectation that key emerging economies (China most notably) will react strongly to any lingering signs of overheating and just as Bernanke might not care that his low interest rates will fuel asset bubbles far from the shores of the US, so may Chinese policy makers care very little if they have to slam on the brakes to the detriment of global growth and OECD’s recovery.