RBS: The bears have killed Goldilocks
Last week I was talking about the Goldilocks scenario for the US. I think it is achievable. But this week, RBS tells us that the bears have killed Goldilocks. They say we should “sell everything”. Of course, I am more bullish than RBS – or I wouldn’t be talking about Goldilocks outcomes. Nonetheless, I recognize the considerable and increasing tail risk enveloping markets. So let me dissect the RBS call and where I think they add value in terms of recognizing and mitigating downside risk.
Upfront, I will say that I believe that we are at a point in the credit and business cycle where medium-term downside risk mitigation strategies are necessary. I am not talking about tactical, week-to-week or even month-to-month strategies, but rather ones that recognize we are closer to the end of the credit cycle, and can thus withstand the onslaught of a recession and bear market. The closest thing I have to a base case for the economy is 2% growth in the US and continued growth in Europe in 2016. But there is significant downside risk to that outcome, particularly given the poor earnings environment in the US.
Before I wrote my Goldilocks post last week, I focused almost exclusively on risk pointing to signals of slowing and a worsening commodities complex. These risks have been borne out and worsened. Moreover, I also highlighted what I see as a real risk of market contagion, and of recession. So I share RBS’ concerns about tail risk – and I think the market and economic story I have been telling over these past couple of months is very much in line with how events have proceeded.
However, I don’t think we are in a 2008-type situation here. Instead I believe we are in an increasingly deflationary period, dominated by demand shortfalls everywhere, particularly in China and that this is only exacerbated by monetary policy divergence and a strong dollar and by the Saudi oil discounting market strategy. All of this leaves the convergence to zero trade intact despite the Fed’s rate hikes.
This sums up the last two months of posts from me. But let me also say again as I did in early November that the Fed could be on a multiple rate hike train despite that backdrop. The last three jobs reports have been good enough for the Fed to continue its rate rises despite the strengthening dollar, worsening data elsewhere and the market volatility. In my view, this policy divergence increases downside risk considerably, and is a major reason to take a defensive posture a la RBS.
So what is RBS saying? From a macro perspective, they are saying pretty much what I have said: “bearish China”, “bearish global commodities”, “bearish oil”, “Emerging market majors (outside India & Eastern Europe) all remain sells”. The biggest difference between their macro view and mine is that I don’t believe the bears have killed Goldilocks. I believe she is alive if unwell – and that under a limited set of circumstances, she could be nursed back to health. So I am concerned about tail risk like RBS. But I am more bullish than RBS, if you will.
China will slow, yes, but I see a so-called hard landing as more of a tail risk than a baseline. The real risk in China is currency – and that means China would export deflation to the degree they allow their currency to depreciate with recent market signals. That is clearly bearish for commodities as the commodities complex is leveraged to China, especially on the industrial commodity and energy side. I can’t say whether ag commodities will follow suit. $16 oil is a certainly an eye-popping call from RBS. And they call this a tail risk scenario, with $26 a firm target. To my mind, this sounds proportionate to the risk in the oil market right now given we are just $4 from that scenario, with the Fed still sending hike signals to the market. And on EM, I am bearish as well. But I believe most of the downside has been realized – outside of a real crisis. So, again, I believe RBS’ macro view is directionally correct. But I do not believe the downside in their scenarios is a baseline; it is a tail risk. And so I would not say there is reason to “sell everything” at this point. I would rather focus on the likely outperformance in safe assets and underperformance in risk assets on a risk-adjusted basis. That means rebalancing portfolios, rather than going short outright.
Let’s take two signals that I follow as an example. First, there is junk. Here’s how I put it last month: “as a former junk bond guy, I tend to think junk is a canary in the coalmine – and for two reasons. First, lower quality credits are more vulnerable to swings in the economy. And second, bond investors are more attuned to downside risk than equity investors simply because bond guys get a fixed income with little or no upside. Right now, junk is signalling problems.” But problems do not connote recession – though Bloomberg notes junk as an economic indicator gives a US recession a 44% probability. Summing up my view, junk bond guru analyst Marty Fridson puts it well when he says:
“I am inclined to be a little bit more optimistic than the calculation taken at face value, in particular because the spread is inflated by the very distressed state of the energy and metals and mining sectors. You could say that if you take out energy, the rest of the market is not indicating a particularly high recession risk, and that’s also a valid comment.”
Expect market death to accelerate in a very real way in 2016 for energy high yield names. This is what I have been saying for nine months. But big banks are not overly exposed here and there is no systemic risk until significant contagion occurs as a result – and until the real economy impact is felt.
Then there is the earnings signal. The Goldilocks scenario is hampered by poor earnings because firms don’t increase wages into an earnings downturn like the one we now have in the US. I see this as an impediment to Goldilocks’ revival in the US. However, in Europe, the opposite is true, with earnings expected to rise some 30% in Q4. That’s supportive of more growth in Europe, against a backdrop of easing. So the earnings signals are mixed. They are not dire and they are not out and out bullish.
Tail risk is real – and it is increasing, especially due to a strong dollar that results from policy divergence. However, I need a lot more evidence to conclude that the bears have come and ripped Goldilocks to shreds. I don’t think we are there yet. The ISM non-manufacturing data say so. The German output data say so. The Irish and Spanish data say so. The bears have entered, yes. And Goldilocks is sleeping, she is unwell. But she is not dead.