Edward Harrison’s Ten Surprises for 2014, Part 1
In 2012, I started off the newsletter with a list of ten surprises for 2012 and I repeated the exercise last year. For me, it is a good exercise to go through to hone my thinking about the economic and investing landscape. And it has been tough to come up with a list over the last two months because I have felt we are at a crossroads in this business cycle. Everyone was bullish as the year began, including me. But that left me uneasy. In the two months since, events have shown me why I was uneasy and now I will begin with the first half of my list.
The surprise list is loosely based off Byron Wien’s list of ten surprises which he has been doing at Blackstone and Morgan Stanley for the last thirty years. Wien defines his surprises as events to which investors assign 1-in-3 odds of happening but which he believes have a more than 50 percent likelihood of occurring in 2012. That’s what I am doing too but I am also making sure that each item on the list has an identifiable target which can be objectively identified before 2014 is over. That way we don’t have to wait to see if these surprises work. If the list is mediocre, I should get 3 or 4 out of ten. If I guess right at 50% odds, I should get 5 of ten. Anything above 5 means I had a good year.
Here is the first half of the list, with four macro calls and two market calls.
- Brazil goes into a recession
- Spanish GDP growth rebounds and outstrips German GDP growth
- Gold rebounds to beyond $1600 an ounce
- US GDP growth in Q2 and Q3 is below 2%
- 10-year US Treasury yields fall below 2.25%
- Abenomics ‘fails’ as Japanese GDP growth slips below 0.5%
Now, let me explain my thinking for each item.
Brazil goes into a recession. The thinking here as to why this is on the list is simple. Only a handful of emerging market economies really matter globally. Brazil is one of them. If the emerging markets has a crisis of global importance, contagion would have to infect a big market. Now, Brazil is one of the fragile five emerging markets economies that is causing tremors because of macro imbalances. The others are India, Indonesia, South Africa, and Turkey. In the first cycle through crisis in June, the biggest economy that was negatively impacted was India. This go round, it has been Turkey. Brazil, while affected, has some fairly good metrics in terms of foreign currency reserves and foreign debt by corporates. So I think a recession in Brazil would shake confidence in those metrics and create another cycle of crisis. Markets believe there is less than a 1 in 3 chance of recession. But I believe the domestic economy in Brazil is weakening more quickly than suspected. And the bubbly housing market coming unstuck will make the downturn more severe. What happens in Brazil will be important, even symbolic, since Brazil is hosting the World Cup this summer.
Spanish GDP growth rebounds and outstrips German GDP growth. I can’t be completely downbeat here. So, in line with my more optimistic view, I am looking to Spain to re-assert its growth ’tiger’ role alongside Ireland. A number of things come into play here. First, everyone is extolling Germany for a job well done. And second, people are less optimistic on countries in the periphery. I think this is wrong-headed and believe that Spain has the best chance of showing why. The Germans are saying their economy will grow 1.8% in 2014. While the Spanish are saying 0.7% growth for their economy. The European Commission has bumped up its forecast to 1.0%. But it is still below estimates for Germany. Morgan Stanley has Germany at 1.4% growth for 2014. But it has Spain at 0.6% growth. Therefore I believe the market would be surprised by German weakness and Spanish strength.
First, Spain is allegedly going to raise its forecast. Second, German domestic numbers are weak. Foreign trade is driving growth. This is Germany’s Achillees heel, especially with emerging markets slowing, the US slowing, and the periphery still weak. Spain is benefitting from lower yields, which will pass through into credit growth at some point this year, increasing Spanish home prices. And rising bad debt will stabilize, further improving the situation. Bottom line: Spain has a basing effect to work from. Having been savaged by austerity, they will benefit from a low base and GDP growth will increase more than anticipated. That’s my call here.
Gold rebounds to beyond $1600 an ounce. In November I wrote that I was neutral to negative on gold after the collapse in prices that I anticipated in my 2012 surprise list actually did come to pass. I didn’t see any positive catalysts. Moreover, lower inflation at the zero lower bound spells increasing real interest rates, a bearish signal for gold, an asset that doesn’t earn a return. But the EM crisis changed this. The move to safe havens may have begun. And gold is one of those safe havens. We are already over $1300 an ounce. So I think $1600 is a very optimistic and aggressive target for gold. That’s my surprise then: $1600 an ounce by year-end. If we get another EM crisis cycle with Brazil at the fore, this is what I expect to occur.
US GDP growth in Q2 and Q3 is below 2%. My thinking here is simple. Everyone is bullish on the US and they see the numbers increasing through 2014. I think that can happen too, but only as a result of a credit acceleration. At the beginning of the year, with yields rising, I could see credit demand being pulled forward, boosting growth. But the emerging markets crisis and bad weather has knocked that back. All evidence that a credit acceleration is coming has petered out. Housing starts are down. Existing home sales are slumping. Capital investment plans are getting scaled back too. So, the sources of credit acceleration look weak. At the same time, wage and income growth is only enough to sustain up to 2% growth. So my prediction here is that 2% growth is all we should believe we are going to get. Below 2% growth would be a surprise that is consistent with a mild inventory purge, this would take everyone by surprise.
10-year US Treasury yields fall below 2.25%. This surprise falls directly out of the last one. If growth in the US is weak, then yields should fall. I keep hearing from various talking heads that they believe inflation is about to break out. And they then say that means interest rates will rise as traders front-run a Fed hike. OK. If that’s so, then inflation irresistible force meet poor wage growth immovable object. Inflation without wage growth doesn’t lead to higher rates at all; it leads to lower real wages which is a fancy way of saying there’s less money in people’s pockets to spend. If we do get this inflation that these talking heads expect, it would only create demand destruction that weakens the economy so much that inventories start to get purged. That’s negative for growth and therefore bullish for Treasurys. I’m looking at 2.25% as an aggressive target.
Abenomics ‘fails’ as Japanese GDP growth slips below 0.5%. Along those same lines, I see Japan’s Abenomics failing. Abenomics has been a boost for Japan. 2013 was a great year as I said it would be in last year’s surprises. But now the tax increases are coming. I wrote the full version of what I see happening last month. The gist here is that, “we want to see then from a cyclical perspective is deficit-led growth fuelling capital investment and wage and job gains that power the cyclical upturn forward”. But that’s not what we’re getting. Instead we are getting resistance to wage increases, a record fall in machine orders, and GDP-sapping record trade deficits. If you add a consumption tax to that mix, you have a very big problem. Morgan Stanley still has Japan growing at 1.3% for 2014. But I believe there is a 50% likelihood Japanese GDP growth slips below 0.5% at some point this year. I see growth for the year as under 1%. That’s when people will see Abenomics as having failed and there will be market repercussions as a result.
As the year forms, I am bullish on Spain, bullish on gold, bullish on Treasuries. But I am bearish on Brazil, bearish on the US, and bearish on Japan.
I am going to leave it there for now. I have at least 4 more surprises coming in part 2 of this post. Stay tuned.