-- This is a guest post by Jay Pelosky, Principal, J2Z Advisory, LLC --
As we approach the mid-year point much of what we have focused on in prior reports remains in the news and active as financial asset price drivers: EU & US debt, growth concerns, fiscal and monetary policy, and EM inflation to name but a few. Commodity prices have swung sharply; equities started the year with vigor but have since sputtered while UST bonds and spread product have done well, to the surprise of most. The growth slowdown we warned of in our April piece: “US Growth Slowdown Ahead: the Dog that Didn’t Bark” is in train.
A new theme that is worth exploring is the notion of “financial repression”, a term first coined by the noted economist Carmen Reinhart. I had the opportunity to engage with Carmen a few weeks ago and her take on things makes a lot of sense. Put simply, financial repression refers to efforts made to reduce heavy debt burdens in a way that does not break the economy or cause great hardship to debt holders. Here is how it worked in the post WW II period when the USA last had a heavy debt overhang. Rather than declare a default/restructuring or put the country through another Great Depression, the decision was made to reduce the debt slowly and in small bites by encouraging domestic investors to buy government debt through both inducement and some coercion as well as running a small negative real rate of interest over a long period of time. This last point is where the real debt reduction takes place as evidenced by the fact that for roughly 50% of the time between 1945 and 1980, the real yield on US T Bills was negative, not hugely negative, but negative nonetheless. As a result of this financial repression and strong economic growth, the post WW II debt overhang evaporated.
Financial repression is in place and on offer today and may present a way out of the enormous debt overhang currently facing the US without either defaulting or pushing the economy and society into another depression. It is not great for savers but it is a middle way, a way without great fanfare or immediate success but one that could work. Today we have negative real rates on US T bills as well as rates far up the curve. We have had a weak USD that has helped to generate some commodity driven inflation, necessary to have negative real yields and done in such a way as to provide the Fed with plausible deniability that inflation is their objective and that such inflation as does exist is transitory in nature.
The other factors at work in financial repression are also at play today - for example, the US Treasury is about to embark on an advertising campaign to encourage citizens to hold UST, something that was de rigueur many years ago but that has fallen well out of favor over the past few decades. Basel III rules will encourage banks to hold more government securities while other regulatory forces are suggestive of the same policy. This is true by the way in other parts of the developed world as well, notably in Japan where local investors, both individual and institutional, are the principal holders of Japan’s large government debt load and increasingly in the EU where domestic entities are being required to hold government paper. If one considers China’s financial system one can see it too is a repressive one in many aspects.
Financial repression does beg the question of how investors will respond to the issue of nominal versus real returns – reflecting in a way the tension between return and safety. UST may give one a nominal return and an assurance of return of principal; for a real return, investors may have to take on more risk and go to the corporate world for stocks or bonds, to commodities, real estate or elsewhere.
Of Booms, Busts and Bounds
Much has been made of the trajectory of global, regional and domestic economic growth. Will it boom, are we approaching a bust? One way to consider this question is to simply divide the economy into two halves: the manufacturing segment and the service segment. Let’s focus here on America. From the early 1980s till 2006-7 the US enjoyed a service sector boom and a manufacturing sector bust (esp. in terms of employment). Over that time real estate in such service centers as New York boomed while it collapsed in failing manufacturing cities such as Detroit. While the US continued to be a world leader in manufacturing output and manufacturing exports it has done so with many, many fewer workers, a point often missed in today’s debate about how to fix the US economy and how we need to rebuild our manufacturing base. In fact, data suggests US manufacturing output has doubled in the last thirty years while the number of workers employed in the sector fell by 40%.
Well, guess what? Today we are in the very early stages of a US manufacturing boom and a service sector bust. Perhaps Detroit residential real estate is a bargain similar to that of NYC real estate in the late 1970s; the FT did note recently that three bedroom townhouses in Detroit are going for $100,000 versus about $3-4 mln in Manhattan. This concurrent boom and bust scenario has major implications for the health of the overall economy as unfortunately for the US, services make up about 70% of the economy and labor base while manufacturing accounts only about 12%, in line with the weight of government employment. So a manufacturing boom will not re-employ all those out of work but a service sector bust will continue to push folks into either low paying jobs or no jobs. The New America Foundation recently reported for example that nine of the ten jobs with the most workers pay well below the mean wage of $21 per hour. Sub-par growth is likely to be the norm for years to come in the US.
Let’s focus on the boom for a moment, which heralds some significant changes in the coming years. For example, it is estimated today that all-in production costs including shipping and transport between China and in the US are basically flat. Given supply chain disruptions post the Japan quake, given climate change and energy cost issues in regards to transport, given the likelihood of continued double digit wage gains in China for the foreseeable future (China labor supply is due to peak in less than 5 years) one can envision production coming back to the US augmented by a surge in China FDI flows as Chinese companies move to where their customers are. The Chinese have brought down the percent of USD based foreign exchange reserves to a level that may well be sustainable for them; perhaps the next step is for a surge in China FDI flows to the US in the years ahead, mirroring perhaps Japan’s massive FDI flows into the US in the late 1980s. Much of this process will be USD supportive as well as UST supportive and perhaps equity supportive as well.
It is also worth noting that China is entering the exact opposite process: a manufacturing sector bust and a service sector boom. Low cost manufacturing is already exiting China for Vietnam and other destinations as China moves up the value added ladder. It is critical for China to rebalance its domestic economy, itself a critical component for the rebalancing of the global economy. The growth of the service sector is a primary component of that process. This is likely to be true in many of the emerging economies over the next decade and may suggest the outlines of a more regional and service based world economic order as the coming infrastructure build out shrinks supply & transport chains to regional rather than global levels and the great global labor arbitrage of the past 10-15 years comes to a close. Regional infrastructure is likely to be a booming business over the coming decade as Asia and LA, the Middle East and Africa get stitched together.
Thus the boom and the bust, now what about the bound? The bound refers to the prospects for financial market price movements to be held in check by various bounding factors such a negative real interest rates for risk assets, real final demand for commodities, yield differences in foreign exchange and other factors as well. This idea is critical as it may help define what the upside and downside parameters for different asset classes might be. To wit, equities have been weak with the FTSE USD Global Equity Index down 4.1% over the past month and up now only 1.9% ytd. The fact that both the US and China are running negative real rates suggest that liquidity will continue to be plentiful, providing perhaps fundamental support for equities (at some yet to be determined level of course). Real demand: for oil, for copper, for food, may well anchor commodity prices, now off 8-10% from their recent highs. The USD has rallied from close to 1.50 to the Euro to 1.40 in the past few weeks, yet with Euro yield spreads of close to 175 bps on the short end and with some commodity currencies (the Aussie) providing 300 bps spread on the long end, perhaps here too USD strength might be capped.
The bounding concept is inexact but it may be helpful in an investing world where many elements are in flux and moving in ways very few investors have had much experience with. The bounding factors are big building blocks and are strategic in nature; investors should consider them together with the more tactical factors such as sentiment, technical analysis, valuation and other more near term issues.
INVESTMENT RISK FACTORS
EU Debt Crisis: Kick the can down the road strategy is running out of road; lack of leadership/discord between ECB and EU politicians over Greece is worrisome as are growing signs of Spanish economic/political drift.
Government Policy Reversals: Dual and simultaneous withdrawal of fiscal and monetary support on both sides of the Atlantic – regardless of whether economies can stand on own two feet. Worse yet, there is no fall back plan.
EM Hard Landing: The KEY risk to global growth with implications for all assets. Inflation continues to be an EM worry, some sign that currency appreciation is being embraced as a solution. China economic slowing in process.
Middle East Unrest: While oil prices have come off, uncertainty remains high in the world’s oil producing center. Bahrain/Saudi Arabia remain key.
Looking out toward the rest of the year and into 2012 it has grown harder to identify catalysts for sharply higher equity prices in either the OECD or EM space while downside risks loom large. Questions continue over growth in the OECD and inflation in EM while the debt issues in Europe are not going away, no matter how fervently policy makers would wish it so. The whole idea of providing official support to Greece to encourage the private sector to roll Greek debt in 2012 has failed and the battle lines have been drawn with both the ECB and the ratings agencies stating any “reprofiling” or extension of maturities will be treated as a default. The outcome is unclear; a best guess at this point is that the ECB will have to provide more funding which should lead to a weaker Euro. One size does NOT fit all and Europe is relearning this old lesson.
Of course, this long train of transferring private debt to public debt and hence onward from the sovereign to the supranational suggests that at some point the ECB might just say no as risk to itself from a Greek default becomes too great – one would want to be in USD and UST at that point. Spain, politically adrift with the ruling Socialists in disarray and general elections a full 10 months away, its growth prospects fading while its housing price adjustment process, (only 15% off highs) accelerates and with youth protests filling the streets may well be the European face of a long, hot summer of discontent. It is worth remembering that European financial assets have been trading off Spain for some time as Greece has been consigned to the dust bin – thus it might pay to observe Spain more closely than Greece. The DSK affair and the transfer of leadership at the ECB suggest continued rear guard action in Europe and likely Euro weakness.
In the US, deficit reduction fever continues unabated while the Fed prepares to allow QE2 to die a natural death. The experiment of seeing how the economy will function without govt/Fed assistance, in fact with government retrenchment looks likely to proceed. In many respects the US economy looks similar to how it did a year ago, before QE2 and before the Obama tax deal, limping along at best with rays of light in manufacturing as noted above, while housing and services continue to be weak. Bursts of activity are visible by consumers but they lack the legs to sustain it, as wages remain weak, gas and food prices up sharply on year ago levels. State and local governments continue layoffs and spending cuts while the drivers of future growth in an era of hands off government remain hard to identify. Does this suggest that UST might decline further – perhaps to late summer 2010 levels of 3.50% on the 30 yr. and 2.50% on the 10 yr.? Is it also feasible to see S&P levels that prevailed last summer (1050 or 20% below current levels)?
One way to consider these questions is to ask oneself what would drive risk assets sharply higher and in turn drive UST and spread product sharply lower? The answer in both cases would seem to be better than expected economic activity in OECD and declining inflation in EM. Are either likely in the next few quarters? It is easier to see an inflation peak in EM than a growth rebound in OECD and yet even the inflation peak idea has many issues, including being held hostage to Middle Eastern political risk and weather risk globally.
From a US perspective the fear is that the economy is not strong enough to do more than limp along, with mediocre job growth while it gradually dawns on investors and voters alike that there is no rabbit in the hat: no QE3 (barring much weaker growth and a much lower S&P), no more tax deals or stimulus plans. The political class is focused on 2012 and yet jobs, taxes and conservation are words rarely heard. The scary reality is that for the next 18 months the US economy is on its own while Europe struggles with its debt woes and the emerging economies struggle with their own inflation issues. This is not a bullish scenario for risk assets.
In such a world, the balance of risk & reward favors a more cautious attitude to risk assets in general and perhaps renewed appreciation for fixed income including the long end of the UST curve and USD EM debt with a bias to USD strength in foreign exchange and food, fuel within the commodity space.
Equity: After a 25% rally from last summer’s S&P lows, caution is the word and raising cash is the suggestion as minor weakness reflecting the energy sector sell off and the sharp rotation into defensive sectors may be a prelude to larger declines. While the S&P is only off 4% from its high, the grinding market suggested in the Growth Slowdown Ahead piece is here and many feel much worse than such a pullback would suggest.
Likely ranges remain 1400 to 1250 in the S&P with downside risk more visible than upside opportunity. Hard landings in the emerging economies bring the 1100 - 1050 level into play. The one factor that might really drive equities lower will be weak earnings, driven in turn by slower than expected EM growth and consumption. A possible harbinger is the low earnings beat ratio for Q1 (60%) and the continued double-digit earnings growth forecasts for the rest of the year and 2012 as well. Can tech lead; will defensive sectors lead the overall market higher? Will reasonable valuation, rising dividends, stock buybacks and M&A activity buffer the downside? US and Japan remain favored regions versus Europe and EMs.
Fixed Income: The pain trade in fixed income has been the relatively relentless rally in UST since the Feb. highs in 10 yr. yields at close to 3.80%. Current 10 yr. UST rates are at 3.10% or so and the question is whether the 10 yr. can rally back towards its summer 2010 yield lows of 2.50%? Reduced supply (issuance running 12% below last yr.), declining maturities (next two years sees lowest maturities since 1990), fewer competitor options as Fannie and Freddie shrink their balance sheet and Govt guaranteed bank debt roll off suggest demand will be more than adequate. Its been a stealth rally to date, suggesting that there might well be more room to go; alternatively one has to come up with a strong growth surprise to drive a rate spike – hard to see from this vantage point. In fact, looking at FI ETFs such as TLT and IEF suggest these instruments look like they may break through resistance and perhaps draw in some fence sitters.
The long end of the UST curve, High Yield and USD EM debt continue to be preferred areas of opportunity as lower long term UST rates flatten the curve, reinforce the appeal of higher yielding spread product (while also giving exposure to the cash rich corporate sector) while the prospect for a rising USD could bring new appreciation to USD EM debt. Munis have benefited from a lack of supply and the tailwind of the Treasury rally; taking some profits here makes sense.
Foreign Exchange: The real question here is whether the USD has made a tradable low - if so this could well build on itself as offshore investors come back in USD financial assets, both debt and equity while FDI flows grow as the manufacturing rebound continues. The Euro’s sell off in the face of the best growth quarter since 2007 is instructive. The past few USD rallies in a secular downtrend suggests 10-15% total upside for the dollar against other OECD currencies is achievable; continued EM currency appreciation versus the dollar is likely as Govts move to use the currency to bring down commodity imported inflation.
Commodities: The sell off here has been brutal and as May month end numbers come out some are likely to have been stung quite badly. While a correction was overdue and healthy the question remains where to from here? USD strength is bearish as is slower growth while negative real rates and abundant liquidity, not least in China, suggest underlying demand will remain firm. Geo political risks remain extant. Continue to watch Dr. Copper for signals about EM demand (nice bounce off support over the past week or so) while agricultural commodities remain hostage to weather and oil the same in terms of ME risk. There may be a play in nat gas on the back of a manufacturing boom in the US.
Infrastructure: This segment remains a favorite and nary a day goes by without some report of rising infrastructure needs or investments in both the OECD and EM. What is most interesting is the development of regional transport and shipping systems within the emerging economies and regions. The idea of a tri polar world: Asia, Europe and the Americas is coming to fruition. Institutional exposure to this theme remains nascent while the appeal of a long dated asset should continue to build in terms of potential pension interest. Any weakness here should be bought.