This week’s newsletter is going to focus on how risk assets are setup given the continuing global growth slowdown and likely policy responses to it. The overall thesis is that shares and high yield bonds in the US are short-term oversold but still above a compelling entry point using a long-term metric like cyclically-adjusted price/earnings ratios. The most important near- and medium-term drivers will be the slowing of earnings in the context of slowing global growth and the policy responses in Europe and the emerging markets in particular.
The macro thesis
Let’s start with a longer-term view using my overall macro thesis developed during the initial stages of recovery. The building block for this thesis goes to Richard Koo’s concept of a balance sheet recession. The private sector in many advanced economies is highly indebted. This doesn’t necessarily inhibit economic growth. However, when interest rates are low, limiting the ability to further leverage, private debt must be efficient enough to spur enough economic growth to reduce debt burdens. Otherwise, debt distress kicks in and either government fills the void with increased deficit spending or private defaults begin to erode growth.
On the government side, there is a continuing debate about the ability of government to transfer the debt risk and shoulder this socialisation of losses. I would like to sidestep this debate and merely assert that regardless of government’s actual limitations, there are political limitations which are pronounced. The scale of deficit spending needed in developed economies to counter the incipient deleveraging is simply too large to be politically acceptable. the size of this credit bubble means that the amount of deficit spending that is balanced by the needed private deleveraging/increase in net savings is going to be politically difficult. Past experience shows that people simply are not willing to run deficits of that size for that long .
Japan is a good precedent here. The dynamics there are similar to what we are now seeing in the US for example. The collapse in property and shares caused the private sector to retrench and deficits opened up as a result, with the government going further through stimulus to counteract the fall in private demand. At some point, deficit hawks called for this to stop and then at least twice, most notably in 1997, Japan tried to close the deficit gap via tax increases only to find that it threw the economy into recession. That’s what happened in 1937-38 in the US and what is probably about to happen again.
What you get instead then is a sort of start/stop in which stimulus is poured on to avert crisis but then stopped due to deficit concerns, causing recession and renewed attempts at stimulus.
My view is that you have needed more bank resolutions, credit writedowns and debt forgiveness from the start in addition to the deleveraging. ‘The people’ actually want this . It is government, siding with bank lobbyists to prop up bankrupt institutions artificially, that has created the problem.
So, that’s the macro view.
Risk assets
Because of the economic rebound we have experienced, risk assets have also rebounded – more in the US than in Europe to be sure. In the US, the market was up over 100% at its highs. The Dow hit a four-year high just this past May 1st. But the warning signs that presage a reversal are growing.
- Dow Transports lagging is a warning sign. The Dow Theory is all about the internal technicals of the market. A market has three trends – a primary trend and medium and short swings. These three trends breakout or breakdown based upon technical signals that show divergence in key sub indices like the Dow transports. When the transport stocks are lagging the Dow Jones Industrial Average, that’s a signal about underlying demand. It signals that while industrials are still powering ahead, demand is weakening and so inventories are building. This is the precursor to mid-cycle slow downs and recession.
- Dow Pacing Losing Streak That Dates Back to 1903. This was last week. Things have improved since but this stat stands out as a sign of weakening market leadership: "he Dow has seen only four “up” days this month, which is tied for the least number of positive days in a month during the index’s history, according to WSJ Market Data Group."
- Narrowing leadership. Last week also saw a shift from a period of more new weekly highs for individual stocks to one of more new weekly lows. This tells you that leadership is narrowing. I have been warning about this for a few months now, using Apple as a case in point. I said that the market ex-Apple was weak both in terms of actual price signals as well as in profits. Negative earnings surprises have mounted and since then even Apple has shown uncharacteristic price weakness, despite a good quarter.
- Margin compression. I wrote that 2012 would be an inflection point toward S&P500 margin compression because profit margins are mean-reverting and global growth is slowing. If you look at the chart of the day from earlier today, you see that this has been occurring since 2010. However, each time the economy fell out of bed, the Fed has been able to reflate things via monetary stimulus that caused private portfolio preferences to shift and buoy risk assets. I do not believe the Fed will do so this go around.
- Emerging market weakness. We should look at the fall in stock markets in places like China and India as a leading indicator of weakening global demand. Moreover, I have recounted in increasing detail how markets like China, India and Brazil are slowing. The feedback mechanism between emerging economies and developed economies should flow back as weakness to the developed economies. Companies that have relied on overseas earnings growth to power the market despite weak demand growth in Europe or the US will find this a problem.
All of these points add up to both technical and fundamental headwinds for shares. The question is the policy response to the weaker growth dynamic.
Policy responses coming
In Europe, the situation presages an aggressive policy response most loudly. Spanish yields are now at 6.66% and so I expect Euro zone policy will turn to relax 3/60 hurdle and to EuroTARP as I indicated at the end of last month. There are increasing indications that this is so both on the fiscal side and on the bank recap side (link in Spanish).
I wrote the following about these issues in April:
Merkel and Schaeuble have got onside and have voiced a commitment toward a growth pact. However, the economic imperatives for Germany are different than they are in the periphery. So, when Merkel and Schaeuble say ‘growth compact’, they still mean something different than Francois Hollande or Mario Draghi. My expectation is that European policy makers will close this gap through negotiation and that some sort of growth pact will be unveiled. Whatever growth pact gets unveiled will be a swag – something not fully growth oriented that also lets up on the Maastricht 3/60 rules. This will be in line with the extend and pretend approach that has Europe lurching from crisis to crisis because the economic situation requires more of a policy shift than policy inertia will reasonably allow. So at a minimum I expect the 3/60 rule to be inactivated or relaxed but I still expect the EU to require fiscal consolidation. Eurobonds still seem to be a non-starter.
[…]
What I think monetary reveals is that it is inextricably linked to the banks. And so I expect this last leg here to play a crucial role. What I suggested last week is that the Spanish bailout may be to recap the banks instead of the sovereign. If the banks can directly access the EFSF and the ESM like a EuroTARP then the banks will be recapitalised on a European-wide level. Moreover, German banks, being undercapitalised, will also need to get EuroTARP funds and so reasonably the Europeans can claim this is not a bailout of the periphery but of the banks. While European voters might grumble about this, given Basel III is looming, I expect they would accept the need to raise more bank capital and that using the ESM/EFSF money is a cheap way of doing it. The goal here would be to divorce the bank – sovereign co-dependency, which would eliminate the sovereign questions for Spain and bring the crisis back to more of a simmering crisis from its present level approaching the boiling point.
I will be watching these two points and updating you as the situation changes.
To my mind, this is right on the money and all of the signs since I wrote this a month ago today point in that direction. So Europe is not making a fundamental shift. It is tweaking existing policy to accommodate the facts on the ground. Unfortunately, this won’t be enough to jump start Europe’s economy and the depression and crisis will continue.
The biggest concerns outside of Europe are China and India. There are competing stories on China. We learn Credit Suisse says 2 trillion yuan may be invested in stimulus in Xinhua’s English-language version. However, in the Chinese-language version officials are saying China has no plan for large-scale stimulus. It’s not clear which case is real. However, the macro case is clear: China’s growth is slowing much faster than expected. See my point that amid plummeting trade growth, Chinese productivity trends are macro bearish and the FT Alphaville piece on China’s ‘1 per cent’ risk. They give a bit more granular color. I think China is experiencing a hard landing and so a no-stimulus case is bearish for medium-term growth.
In India, GDP is decelerating very quickly. See the post highlighting my view that India will be worse than China. Rather than repeat what I say there, I will just point out that India’s policy responses are more limited in scope than China’s because of inflation, current account and budget pressures. That tells me that India’s slowdown is likely to be more severe than China’s.
And of course there are other countries like South Korea and Brazil which are slowing as well. The bottom line from emerging markets is that they are not going to be able to pick up the slack left by Europe. Andy Lees is on the money when he wrote about Asian emerging market charts in a recent note to investors:
The second chart shows the combined trade growth (ie import growth plus export growth) for Korea, China and Taiwan all added together. As you can see it has only been lower for a sustained period in the 1998 Asian crisis which required a 25% decline in the Asian dollar index to rectify, in 2001 after 9/11 and of course at the end of 2008/start 2009. Forecasts for May which come out in the next few days are for Taiwan’s imports and exports to fall 4.8% and 5..2%, Korea’s to fall 2.3% and 1.1% respectively, but for China’s to rebound 5.5% and 7.2% which will leave the index basically where it is. Given that the APAC macro surprise index is 43.1 points lower than a month earlier, it seems a little unrealistic to assume this particular data will be better than in April.
This leaves the US. I wrote at the end of last month that:
The Fed has really begun its third easing campaign. It’s not quantitative easing but rate easing/permanent zero they are engaged in. It started out as a 2-year trade, then the Fed has re-upped this by moving out the curve to three years. How could the Fed do more if the economy weakens? That’s what everyone is asking…
…[Bill] Gross says he now doubts whether we will see another round of quantitative easing in June, but that "if we see some weak employment reports over the next two months, then QE3 is back on." He also said that there’s a risk of a double-dip recession “if liquidity disappears.”
I think Gross is right. We are too close to a general election to think QE is coming. Moreover, the record low rates in both government and mortgage yields tells you lowering interest rates isn’t going to be particularly reflationary at all. So, the Fed doesn’t have a mandate to do much of anything right now. Either the incipient cyclical housing recovery helps get us over the hump or the US too will be unable to pick up the slack left by Europe. In the context of high trend growth rate correlations to Europe, this is significant. It says, the US will continue to decelerate as Europe remains in recession, with the emerging markets unable to pick up the slack.
Conclusion
The predominate secular ‘flation’ is deflation more than inflation or hyperinflation. The debt overhang is simply too large to expect anything else. From an investing standpoint, consider this a secular bear market for stocks then. Play the rallies, but be cognizant that the secular trend for the time being is down. In my view, we are nearing the inflection point where the rally is starting to fade and the secular trend down will re-assert itself. That means holding lots of cash and waiting for the right moment to deploy it.