It‟s only just begun...
To kick-off, please be careful about taking too seriously views which claim that the
markets, over the last few weeks and months, are over-reacting, or views that claim
that markets are behaving in a surprising manner. Whilst precise timing has surprised
even me a little – see below – anyone who has followed my work or Kevin‟s work over
the last few months and more broadly since late 2006/early 2007 will know two things.
First, rather than an over-reaction we both feel that markets are, finally, beginning to
price in the kind of „new normal‟ which we have talked about for years. The one where
weak trend growth and fast-deteriorating policy credibility and poor policy effectiveness
are the norm. This process has only just begun. It will not be a straight line down, but
the secular (bearish) trend for risk assets is, to me, now clear and, with hindsight, this
bear leg began in Q2 2011. Second, the drivers of this bearish secular trend are
precisely those which we have been writing about at length over the last 10 months, so
one should not see any of this as a surprise. Turning now to a number of more detailed
1. I was wrong on the very short-term tactical call. I got greedy. I was looking for
one last mini bull-run up in risk as the perfect set-up ahead of the resumption of the
secular bear. I felt that sentiment and positioning were pointing to one more move
higher. Also, S&P moved its US sovereign rating at least a quarter before I had
expected. Nonetheless, I am mighty glad I refined and highlighted my S&P 1280
bear alert level/stop loss in my last note in July. Phew!
2. To reiterate, I am bearish on a secular basis, and in the big picture we have
now commenced the third leg. Leg 1 was the nasty bear from the Q3 07 highs to the
Q1 09 lows. Leg 2 was the policy-funded rally from Q1 09 to Q2 11. This Leg 3 will, I
think, last deep into 2012, and likely beyond. We are in a balance sheet recession
which will take at least 2 to 3 more years to clean up. The cost of capital will keep
rising. The outcome is weak trend growth – I feel 1% pa on a 2 to 3 year basis in the
balance sheet impaired West is the central case. Soft patches will be the norm.
Cushions against economic shocks will be thin/non-existent. Aggregate real Earnings
and Incomes will stagnate/fall. Defaults (amongst weak balance sheet corporates,
consumers, AND sovereigns) will rise and P/Es will fall. In this world, and using the
S&P 500 purely as a risk proxy, I see 'fair value' for the S&P down in the 800/900
area. I think we will see these levels trade in the next 12/15 months. And we may
even „undershoot‟ to levels last seen at the lows of Q1 09. For this year I still expect –
as I have said all year – that between now and end 2011 the S&P will trade, as a low
print, in the low-1000s.
3. In my view the market remains too optimistic and full of hope. In particular the
sell-side remains too hopeful on trend growth. (I think Q2 11 US GDP will be
revised down heavily, and H2 11 and 2012 expectations are, I think, way too high.)
Further, the sell-side remains way too addicted to policy and policy makers. Over the
next year I feel that all the things we have talked about all year – weak trend growth in
the West, growth risks in EM as the focus remains on combating inflation and
excessive credit creation, euro zone restructuring, and fast diminishing policy maker
credibility, policy ineffectiveness and policy options - will get priced into markets and
asset prices. These last few weeks and months are the beginning of this process.
As I write all eyes - for now - seem to be focussed on Bernanke and Jackson
Hole. Why? I don't know. After all, QE2 was – in the eyes of, many - a dramatic
failure. Bernanke will likely disappoint the more bullish expectations with his
Jackson Hole speech, but as I have said all year QE3 is coming in late 2011/early
2012, once S&P trades at 1000 and once the unemployment rate hits 10%.
However, if QE3 comes as a de facto redux of QE2, then this will I feel be a major
policy error. It may „help‟ markets for few short weeks, but in reality such QE3 will force
EM to slow down even harder (China hard landing anyone?) as such a form of QE3 will
simply reignite food and energy price inflation for EM. And for the West such QE3 will
simply act as an even bigger de facto tax on the Western consumer. All at a time when
„official‟ fiscal policy is already being tightened in the West. I think that any QE3 which
is a de facto redux of QE2 will be a critical step towards a collapse in policymaker credibility amongst the markets and amongst the real economy.
4. The secular bear market will not be a straight line down in my opinion. Short sharp counter trend rallies will occur, but the secular trend will be clear. Such rallies will sometimes be driven by the occasional „strong‟ patch in global growth. But in particular look out for Fed QE3 (as mentioned above), and QE2 in the UK (I think the UK has a more credible case for more QE than the Fed). Fed QE3 (see above) late in 2011/early 2012 will likely drive the sharpest such counter trend rally. And markets will likely seriously start pricing it in beforehand, likely once S&P hits low-1000s and once (even) the (official) unemployment rate hits 10%. Such a QE3 may see the S&P move from the low-1000s (my long stated low target for the S&P for 2011, which I expect to see in the next 2 months) back up to say 1200.
QE1 had a useful shelf life of about 12 months and about 600 S&P points. For QE2 this useful shelf life was six months and worth about 300 S&P points, and the period of 'usefulness' expired well before QE2 'officially' ended. So, for any QE3 which is merely a de facto extension of QE2, I'd expect it to have the same half-life and thus a useful shelf life of, at best, three months and be worth no more than 150 S&P points. Very tradable, but a mere blip in the bigger picture. Such QE3 will not work to achieve sustainable (even just) 'OK' growth, and it will just be another example of the fact that policymakers continue to misdiagnose and thus mistreat our problems. Such QE3 will simply be another example of the gross misallocation of capital by Western policymakers. This ugly policy error is getting the expected response from the real economy and the private sector - they are „hunkering down‟ and getting prepared for bad times ahead. Time, and ultimately the rejection of the print/pump/borrow/spend policy framework, still deeply embedded in the West, will be the cures and will drive, in time, a sustainable recovery led by the private, and not public, sector.
In the euro zone, the options are clear I think. It's either full, explicit fiscal union where Germany and the inner core pay up. Or we end up with a 'neue-euro zone' in which certainly three, and perhaps more, of the existing members of the current club – those with the weakest balance sheets – are „ejected‟ from the euro zone (not from the Euro) and put under some form of multi-year „conservatorship‟ for 3/5 years, during which time these economies undergo meaningful debt and economic restructuring, with conditional assistance from Brussels and the ECB. This means genuine default and real bondholder losses. I cannot see any other solution.
Full fiscal union is many years away. So genuine and meaningful debt and real economy restructuring seem to me the only choice realistically. The longer we wait, the lower the recovery and the bigger the risk that three goes to five or maybe even six existing members. The sooner the euro zone gets "fixed" real the sooner we can move on. If we can get to this point quickly, then I am pretty certain that markets will be pleased to see a sustainable resolution and this, as well as US QE3 or UK QE2, will be an outcome which can also drive a short sharp counter trend.
5. So, what should investors do? On a two to three year timeframe, the old rule applies. Focus on and favour strong balance sheet entities, whether its government debt, consumer debt or corporate equities. Strong balance sheet, large cap global blue chip non-financial equities and debt will I think offer the best relative value and best risk reward. On a one-year timeframe I would be extremely risk-averse and outright bearish. And in the very short term, I look for a low-1000s S&P print this year, but thereafter I would also be expecting, as discussed above, to see one last policy-fed hurrah which could see, as a proxy, the S&P up at 1200 by end 2011/Q1 2012. Gold should continue to ramp up, largely irrespective of what happens to commodities in general, as on a two- to three-year timeframe we are – I am sure – going to move away from fiat money and the failed economic thinking of the last 30 years. For now I do not have any strong FX call – I think 2013 could well be the year in which we get the major global currency/money paradigm shift which will be a core part of the longer term solution to our global growth and Western debt ills, but this is a topic for discussion later. As for core rates – the US, the UK and the inner core euro zone - on a 12 month basis I can see 10yr government yields in the US UK and Germany down at 1.5%, maybe lower. If my nearer-term 2011 S&P target is going to prove correct (low-1000s target) then expect such 10 year yields to break below 2% and perhaps even 1.75%. On a QE-fed counter trend risk rally, core governments will of course sell off, maybe to mid-2s in yield terms. On a 12 month horizon I suspect this will be a great entry point.