Today’s commentary
Welcome to 2014!
I am in good spirits as the new year begins. But it is key not to let that mood leak out into my analysis of what’s to come. Clearly, most analysis for 2014 is upbeat. Economists are predicting higher global growth, higher U.S. growth, an end to the sovereign debt crisis and all manner of positive economic outcomes. And I think all of this upbeat analysis is justified. Nevertheless I want to give a more balanced view of what’s on my mind regarding markets and the economy as the New Year begins.
It is nice to be able to write a post on a hodge-podge of topics for once because the daily commentary format means I often leave out some important themes as I scan the scene for important bits to highlight. So I am looking forward to writing this post.
The Fed
Let’s start with the Fed. 2013 was a big year for the Fed. It seems everyone was talking about quantitative easing and the Fed’s tapering of large scale asset purchases. It almost became over-analysis in the sense that tapering is only so important to the real economy. People act as if it is the only thing driving real economic growth. And I think this obsessive talk about QE highlights why the Fed wanted to taper. Irrespective of one’s analysis of the effectiveness of QE and its transmission into the real economy, quantitative easing is clearly unconventional and therefore controversial monetary policy. QE is an attention-grabber economically and politically. The Fed does not want to be the center of so much unwarranted attention. And so to the degree possible, it is trying to get away from QE. That’s why tapering was important.
But I have seen some good commentary on the Fed’s policy aims for 2014 recently that I haven’t had an opportunity to comment on. Let’s start with Tim Duy, whose commentary is always perceptive. He had a trio of posts – On Challenging the Fed, Inflation, Wages and Policy, and What Comes After the Evans Rule? – that I want to role into one big commentary. In the first of those three posts, Tim notes the following:
Policymakers will be alert to signs that recent gains in rates look to be driven by expectations that the Fed will hike rates sooner than suggested by the Fed’s own forward guidance. Relying on the separation principle so well defined by Gavyn Davies, the Fed would be less concerned with rate increases driven by a higher term premium. Using the two year Treasury rate as a proxy for the forward path of short rates, however, it looks clear that market participants are fundamentally reassessing Fed policy:
Note too that recent movements are not in response to higher expected inflation, and thus represent rising real rates:
Given that bonds had their worst year since 1994, you have to wonder whether we are seeing a dramatic change in the yield environment. Yet again, punters are front-running the Fed because they think the economy is moving full steam ahead. For me, this sets up a dilemma. If you are bullish on the economy, you might see the Fed as behind the curve, meaning the frontrunning is justified, and that makes one want to shorten duration, a positioning that was worked out well for 2013.
On the other hand, this could be yet another head fake. And if it is, the Fed is now boxed in because it has already started tapering. Despite the rhetoric, I don’t see the Fed INcreasing asset purchases unless the economy falls out of bed. The Fed IS tightening. Tapering IS tightening. I don’t care what everyone is saying. Let’s remember that both broader and core measures of inflation are actually falling right now, not just in the US but globally. Yet the Fed is tapering asset purchases and moving dangerously close to the 6.5% unemployment threshold that marks the beginning of a tightening bias. The Fed can finesse its forward guidance all it wants; when we get to 6.5% we will be in a different world.
I told you I expected a Yellen Fed to take a rules based approach to forward guidance, meaning that the Fed understood the time inconsistency problem of trying to get markets to move on its guidance and would address it this way. This is out the window now; nothing Yellen or any other Fed officials has said points to a rules-based approach – just the oppositie. The Fed is making it up as it goes along. The 6.5% unemployment threshold remains and I believe it will become completely irrelevant, undermining forward guidance in a major way.
How do you play that potential outcome? I see this as less a bond play and more of an equities play i.e. an end to multiple expansion and the denouement of increasing market risk. To me, this says 2014 could be a more interesting year in terms of volatility than we believe it will be now at the outset. Remember also that real rates are now increasing.
So that’s my view on the Fed.
Equities
I think the message from the Fed analysis plays into one’s thinking about the equity markets then. We are riding multiple expansion in a big way. Some people are trying to finesse this in a way that leaves me uneasy. The reality is that economic growth often equals multiple expansion. The question is what happens during the subsequent downturn. How violent is the pullback? Henry Blodget’s piece on a catalyst for a market crash is a very good piece on a good way to think about this.
If real rates are increasing, the peak in economic growth turns out to be in the rearview, and earnings guidance is negative that sets up the market for volatility. I expect 2014 to be a good year economically. And that is good for stocks. However, the setup is very goldilocks-ish, meaning we need to see good outcomes to validate record market levels on the back of a 25%+ year and vast multiple expansion. Mediocre outcomes will not be enough.
I am going to leave it there but also recommend you read Crossing Wall Street’s piece on its buy list for 2014.
Japan
I don’t need to repeat my caution on Japan again. I will say this though: I was bullish on Japan at this time last year and I predicted Japan would outperform. It did. The question, however, is whether or not that outperformance was predicated on secular changes in economic growth, something that would mean a secular bull market in my view. The jury is still out. And the thing to focus on is that Shinzo Abe is not a reformer per se, but a nationalist. I think this is important to keep in mind. It’s not that Abe is turning Japan around because of bold new ideas. Rather, he has the same old ideas but he is using them more aggressively because his nationalistic streak dictates this. The question is whether the aggressive policy gives the economy enough push to get Japan over the hump politically. I don’t see it. Instead, what I am seeing is the beginning of conflict in Asia that is worrying. Take a look at this piece from James Fallows on Yasukuni. I found it enlightening – and it definitely supports my contention about where Abe’s motivations are.
China
Here we have a perfect example of economic resiliency on the back of loss socialization. This is what the workout period of our financial crisis has been all about. China house prices are showing signs of stabilizing as a result of the Chinese government’s crackdown on bubble-inducing credit. Yet, at the same time, local governments, through whom, a lot of property-based speculation was financed, are having a tough time. Loans to local government are being rolled over, evergreened so that the extend and pretend strategy allows the losses to be absorbed over a longer period. We are talking about a $3 trillion problem here though. That’s why growth has slowed and will continue to slow. The question is how much growth slows and what the policy response to its slowing is. So far what we see is an inability to make the transition to a domestic demand-led growth strategy without the economy tanking as the bad loans from the infrastructure-led strategy sour. So every time the Chinese crack down on excess credit, we get these hiccups and panics which are met with easing. I expect this strategy to continue but for growth to slow as it does. How long can this continue without a phase-shift type of growth trajectory? I don’t know. So far the Chinese economy has slowed gradually. But the risk is there that we do get a kind of phase shift down. I don’t expect it in 2014.
Greece
I thought it was interesting that the Greek president remarked that he believed 2014 was the year that Greece left the European bailout scheme and moved to an Ireland-style escape where it gets funded by the bond markets. Iam extremely sceptical of this outcome but it bears thinking about the upside here. Greek bonds are still trading at elevated yields as this chart via Paul Krugman attests.
The chart shows Greece to be a clear outlier and this goes to my scepticism that Greece can pull out of the bailout mechanism free and clear like Ireland. Greece’s trump card, however, is its potential for self-financing its future budgets. To the degree that Greece continues its budget trajectory, it may not need to fund new spending at all. Instead, with a primary surplus, it may need to go the market only to refinance existing debt. If this turns out to be where Greece is by mid-year AND the economy is also growing, suddenly you have the potential for debt sustainability. It sounds a bit far fetched, yes. But this is what Samaras, the Greek PM, is talking about. What he wants is for market yields to collapse on the back of this news and for the vicious cycle to turn into a virtuous circle of self0financing, lower interest repayments, economic growth and declining government debt to GDP. Something to think about
This AP story ends, summing it up well:
Still, the weakened economy is set to be burdened by a national debt of 176 percent of gross domestic product this year, leaving Athens in vital need of additional debt relief from its emergency creditors. Samaras wants to avoid seeking additional loan money to cover an expected budget shortfall in 2014 and instead hopes to return to bond markets after a four-year absence.
“A critical factor is the whether there can be at least a modest bond issue on the international markets. That would mark the end of the bailout program and could have a significant political effect,” said Theodore Krintas, managing director at Attica Wealth Management.
“So I think 2014 will be a year with no middle-ground scenario. Things will either go well, or they will go badly. Either they will develop much more positively than 2013, or it’ll be a year of great turbulence. It won’t be business as usual, that’s for sure.”
Could Greece have another monster year because of this? Yes.
I am going to end it there. There are reasons to be bullish. But in the US, market multiples look stretched. And if we don’t get a Goldilocks scenario on the growth front, it makes the market vulnerable to a violent correction or crash. That said, on the whole, the outlook is positive.
Welcome to 2014.