Edward Harrison’s Ten Surprises for 2014, Part 2

By Edward Harrison On Feb 26, 2014

Yesterday, I began my Ten Surprises List. As a reminder, 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 2014. 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.

As it turns out though, I am going to add in more than ten this year. In addition to the six from yesterday, I have eight more today, four for the list and four extras.

Here is the second half of the list.

The US stock market falls as profit margins begin to decline
US high yield spreads begin to rise
Greece 2-year bonds rise gets access to market for bonds out to 5 years
France underperforms as housing market cracks

Plus:

Canada’s housing boom stalls
China’s growth slows in at least two quarters to a 6% annualized rate
Australia’s housing market declines
Argentina defaults and takes pole position from Venezuela on inflation

Let’s start in the US.

The US stock market falls as profit margins begin to decline. Yesterday, I wrote that we could see the US stall with GDP growth coming in under 2% in Q2 and Q3 to go with Q1’s poor number. That would e serious weakness. And clearly, that weakness has to be reflected in corporate profits in some measure. Corporate profit margins are high right now. So I believe, slow growth will impact them negatively in a way that slows earnings and causes the US stock market to fall. The question is whether the market can rise in the face of slowing earnings via multiple expansion as it has in the past. I say no, multiples are more likely to contract than expand.

US high yield spreads begin to rise. If the US has poor growth and if there are further catalysts for crisis in emerging markets, I don’t think that US risk markets can withstand the pressure without contagion. That would suggest the low AAA/BAA spread will start to widen. Right now BAA paper is trading about 67 basis points wide of AAA paper. And that is up marginally from a cyclical low around 63 bps. I think this number will go higher as the conditions in the real economy deteriorate.

Greece 2-year bonds rise gets access to market for bonds out to 5 years. At the same time, I am still betting on the recoupling of the periphery. Despite increased volatility, I think the recoveries in the periphery are real, if only because we are working from a lower base. Dead cat bounce or not, we will see this translate into earnings growth in the periphery. Therefore, I expect periphery equity markets to outperform. They have done in the first two months of the year. But the call I would rather make based on that has to do with the Greek bond market. I think Greece with its current account surplus and its budget surplus will regain access to the market beyond just 3-month paper. I am saying the Greeks wll place bonds out to five years and this will reduce yields and increase bond prices across the curve, particularly in the 2 to 3-year area. The reason Greece can auction 3-month paper is because it is short-dated. I think people will become more comfortable with 1-year or 2-year paper once the next bailout closes.

France underperforms as housing market cracks. On the other side of that, I see France as a weak link in Europe. The EC is saying the economy will grow 1% this year. I don’t see it. Morgan Stanley has France at 0.4% growth. That sounds like a more legitimate number. Even so, the EC says that France’s budget deficit will increase to 4% this year. That will be a political problem. My call here is that France will do worse than anticipated i.e. growth will be lower than 1.0% for the rest of the year. Q2 and Q3 growth will come in much less than that. Recession is an outside possibility. The reason: housing. France is on everyone’s list of overvalued markets. And house prices do not rise when the economy is stuffed. They fall. The feedback between the real economy and house prices will be negative in view of the French banks’ undercapitalization, something the ECB stress tests will highlight.

Now I don’t have to make any more because that gets me to ten but here are four bonus surprises that I think may be important.

Canada’s housing boom stalls. The real economy in Canada has stalled. Nouriel Roubini is talking about the Dutch disease and recommends monetary easing. The Canadian leverage to commodities is an Achilles heel, especially in view of weaker growth in the US, Canada’s major trading partner. It is clear that a lot of Canada’s success is due to a house price boom which makes the Canadian housing market one of the world’s most overvalued and keeps household debt at record levels. For example, an article in the Financial Post says that the median net worth of Canadian families jumped 44.5% to $243,800 in 2012, up from $168,700 in 2005, using this as proof that all is well in Canada. This is clearly housing related, and to the degree the real economy slows enough, the housing market will cool again. Rather than predicting a crash for 2014. I will predict no growth i.e. a flatline. But eventually, we will see a fall in this market because the gains are unsustainable. And note, last year I said the bubble would pop. It hasn’t but it will.

China’s growth slows in at least two quarters to a 6% annualized rate. This surprise is predicated on the fact that China wants to slow credit growth but housing is weakening so much that the growth rate in the economy will slow a lot before the authorities can respond with policy loosening. In previous rounds of tightening, I have called 5% growth a hard landing, but that is from a 9 or 10% growth rate. Now, we are looking at 7.7% growth slowing to 6%. That may not seem like a lot but I believe it will be all that the Chinese are willing to broker for fear of social unrest.

Australia’s housing market declines. And despite the fact that a slowing to 6% in China is not a lot, it will be enough to crater the Australian housing market. Unemployment is at a two-decade high in Australia. Meanwhile the fiscal situation is going more into the red. I think this will mean austerity. So the austerity combined with weak demand for Australian exports will be a real strain on households and that will be a big problem for Australia’s housing bubble. We have been here before. In 2012, I said we would see house price declines – and we did. But the Chinese reflated their economy and Australia benefitted. Now, the downdraft will occur again. And this time I do not think Australia is going to recover because the macro data are already weak.

Argentina defaults and takes pole position from Venezuela on inflation. I foresee a negative ruling from the US courts on Argentina’s sovereign debt standoff. And so I believe Argentina will default on its debt this year. That’s the prediction. But I think more worrying is the real economy there, where inflation has accelerated. I am predicting the inflation problem will get worse and surpass Venezuela, which is presently the worst in the world for inflation. The result will be an economic disaster and serious opposition to Fernandez as Argentina’s leader. If things get bad enough, it will have spillover effects into Brazil and the rest of the emerging world.

That’s it for now. Expect me to be following these stories as the year progresses. I think 2014 will be a dynamic and interesting year economically and in the markets.