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And it ain’t pretty.
Nomura strategist (and former FT Alphaville guest editor) Bob Janjuah is out of hibernation again.
Bob reckons we’re still broadly in a risk-on phase but don’t worry (or, actually, do) because there’s a downward secular shift ahead. The Fed’s “intentional” mispricing of the cost of capital and balance sheet ill-health should see to that.
Overall, the issues leading to the 2007-09 crises are still present, and are even worsening in some places. Namely very large global, regional, sectoral and national imbalances (in areas such as incomes, earnings, wealth, trade and financial health); excessive levels of, and excessively narrow concentrations of, debt primarily in Western economies; and significant fat tail risks in the market when it comes to the price of and the levels of assumed volatility. It seems that collectively we learnt nothing from the 2007-09 experience, and the apparent solution to the crisis has been to implement more of the same policies that caused the mess in the first place.
Therefore, as we have said throughout the past four years, we think the key drivers of markets and economies are still the cost of capital (CoC) and balance sheet (BS) strength/financial health... Since early 2009, primarily through quantitative easing (QE), the CoC fell and has been artificially mispriced in our view since then. This lower CoC also had the usual consequences: more leverage, more debt, and artificially supported, or mispriced, (risky) asset valuations.
Our secular asset allocation theme is unchanged "“ a rising CoC period is, broadly, a risk-off phase, where the strongest BS entities (be they corporate, financial, government or consumer) should relatively (at least) outperform. A falling CoC phase is broadly about risk-on and favours the weakest BS entities. The period from 2007 to early 2009 was a rising CoC, risk-off phase. Early 2009 to the present has been a falling CoC, risk-on phase, albeit punctured by some brutal sell-offs that ultimately forced the Fed into QE2. We strongly believe that the next major secular trend, which will likely begin in 2011 and last through 2012 and maybe even into 2014, will be a rising CoC, risk-off phase where the weakest BS entities will underperform the most.
The transition from our current phase to the next could take two paths, argues Bob. First, a “soft” landing scenario:
In the soft landing scenario, where we expect voluntary global policy tightening, driven by EM, we would expect 1350 S&P to act as a ceiling, and this sell-off to end with a 20% fall (from the February) peak to (the end-Q2) trough. Such a sell-off would in our view create a very positive TACTICAL buying opportunity for risk, as it would be the ideal "pause that refreshes" and would take the pressure off global commodity prices, the building global inflation risks, stretched risk asset valuations, and reduce the pressure on rising bond yields in DM.
Second, you guessed it, a “hard” landing scenario. And by hard he means diamond-, even wurtzite boron nitride-hard.
Under the hard landing scenario we would expect global policymakers to make even more policy mistakes by failing to tighten, and even more worryingly, by accommodating price shocks, especially in EM. Under this scenario we would expect the 1220 support level to hold for the S&P in Q2 2011, and we would look instead for another melt-up in risk assets over Q2 2011, with the S&P peaking at 1400/1440 by end-Q2. This then would be followed by a very difficult and bearish H2 2011 for risk, as the melt-up in commodities, valuations, expectations, sentiment, inflation, positioning and bond yields would together give the perfect backdrop for a severe hard landing in risk assets.
Key here is that QE3 would be delayed until late 2011/early 2012 because of the extremely negative impact that the Fed's QE2 has had on inflation (globally) and the significant concerns already building about the Fed's credibility. We think QE3 is still likely, but judge that risk asset markets and the US economy (notably unemployment) will have to worsen considerably before the Fed can make a "credible" case and garner consensus support for QE3.
Our view is that over H2 2011, under the hard landing scenario things will get a lot worse. It seems to us that very large amounts of debt and money printing are being used to "buy" a recovery which itself has no real legs (in particular as EM "“ the BICs "“ are forced to slow because of their domestic inflation, thus stopping dead the global manufacturing super-cycle which is the only real source of strong growth in the US). And once QE2 stops and other such stimuli are also turned off (fiscal boosts have already had their day, in our view) we think the emperor"?s new clothes will be revealed for what they are. Although in this hard landing scenario, in the initial melt-up we think the S&P 500 could reach 1400/1440 by end-Q2, by end-2011 it could be below 1000.
Which one do you think Bob sees as most likely?
All the evidence of the past few weeks points to the "melt-up then hard landing" path as being the most likely, although for now 1220 and 1350 are still holding, so we still see some hope "“ albeit diminishing rapidly "“ for the soft landing outcome.
This would leave the Fed with the “unavoidable” decision to implement QE3.
All other policy options have been exhausted in rich countries, says Bob. But, his argument runs, this wouldn’t happen until things got really bad (S&P at 1000 or below; rising unemployment) as the Fed is running out of credibility.
And when it does go for QE3…
Assuming that the QE3 option is eventually exercised (as we do under the hard landing outcome) and assuming it does what we fear to the credibility and status of the US, the US dollar and US Treasuries, then we think the result, most likely at some point between 2012 and 2014, will be major fx regime changes and significant paradigm shifts in global fx markets.
That’s more like it, welcome back Bob.
Full note in the usual place.
Related links: On not accepting QE3, with Bob the Bear – FT Alphaville Bob the Bear comes out of hibernation – FT Alphaville
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