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January 05, 2012 • James Shinn
Page 1 of 7
Some traders ruefully describe 2011 as “shockingly volatile,” even as others are pricing new Ferraris in sleek showrooms on Park Avenue and in Mayfair. What combination of asset volatility and fast-car returns is in store for 2012?
In the June 2011 issue of Institutional Investor, I described a reference scenario of the events that global macro traders believed to be moving markets last year, based on a two-day conference at Ditchley Park in Oxfordshire, England. According to this scenario, global macro hedge funds were focused, laserlike, on just four key events: the Federal Reserve Board’s monetary stance, a Chinese hard or soft landing in terms of GDP growth, euro zone stresses and that perennial favorite, oil prices. As I explained in my previous article, “with four big events, there are 16 possible outcomes (two to the fourth power) in the reference scenario ‘decision tree.’?”
With the benefit of hindsight, how did these scenario events actually play out, and how skillfully did our traders predict the four outcomes? Are the same cyclical and secular drivers of these events still at work? Looking forward, will these be the four key variables in 2012? And as the accountants tally up hedge funds’ year-end winners and losers, what is the reference scenario for 2012 — and with what odds?
The Fed’s Stance: Loose or Looser
The Federal Reserve’s monetary stance is the first big event under traders’ scrutiny, as the Federal Reserve Open Market Committee’s decisions will drive asset markets around the world, for good or for ill.
One branch leading from this decision is moderate economic recovery, reflation of price levels, sustained U.S. government deficits, a slightly tighter Fed stance (and no more quantitative easing), gradual improvement in job creation, gradual repair of household and bank balance sheets, and a sideways movement of the trade deficit. In this branch continued dis-saving by Washington is matched by household savings and the purchase of Treasury debt by foreigners and Ben Bernanke’s Fed, and this is what powers GDP recovery — at least for a while.
The other branch of this part of the decision tree says this party can’t go on for much longer and leads to slower economic recovery, flat employment and selective deflation (or the dreaded “stagflation”), some nominal reduction of the federal deficit, a continued expansive Fed stance and gradual shrinkage of the trade deficit. The former branch might be described as “business as usual,” the latter as “malaise” or “painful adjustment.” At the end of the day, the latter scenario writes off QE2 as a dangerous illusion.
“Future Shocks,” June 2011
Original Prediction: Painful Adjustment
Traders in our poll overwhelmingly bet on the “malaise/painful adjustment” outcome, 68 percent to 32 percent (with a standard deviation of 17 percent). The individual arguments supporting this view reflected global macro traders’ conviction that long-term adjustment is crucial — “This party just can’t go on forever,” one trader explained. The traders were also confident, in some cases adamant, that financial markets would force a fiscal deficit reduction in Washington: “If Moody’s gives the Treasury a downgrade, even Congress will have to pay attention,” was a popular comment. Most traders have a visceral dislike of quantitative expansion in any form — “QE is just a central bank’s monetization of government debt, any way you look at it,” observed one trader.
I should add that all quotes in this article are guaranteed genuine, but some of our traders’ firms have blanket policies forbidding their employees from being quoted in the financial press.
Actual Outcome: Business as Usual, Plus ‘Twist and Shout’
Contrary to the traders’ average prediction, we are still heading up the “business as usual” branch at the start of 2012, with no real deal on the U.S. fiscal deficit and with another shot of QE via September’s Operation Twist, although, unlike QE1, the Twist was balance-sheet neutral for the Fed.
The U.S. federal deficit in fiscal 2011 was -8.6 percent of GDP, barely down from 2010’s -9 percent. According to International Monetary Fund forecasts, the U.S. fiscal deficit will shrink only slowly, stubbornly sticking above 6 percent five years out. Consensus forecasts for U.S. economic growth are 1.8 percent for 2011 and 2 percent for 2012, with unemployment running at 9 percent and 8.7 percent, respectively. Even as government debt continues to climb, households will deleverage very slowly, and the external trade deficit will keep running at the 3 percent–of-GDP level more or less indefinitely.
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