Tide Has Turned in Favour of Risk 06102011

8/3/2019 Tide Has Turned in Favour of Risk 06102011

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Page 1 of 12 22 April 2012

Tide has turned in Favour of Risk

It is always darkest just before the day dawneth [Thomas Fuller 1650]

When we wrote our annual UK Capital Market Outlook note (appositely entitled Gold and OtherCommodities Hold the 2011 Capital Markets Key), last December, it was predicated on consensusforecasts being realistically based. As we have all discovered, the recession was deeper thanpreviously calculated. This latter point is very important and goes a long way to explaining the lack ofeffective and demonstrable political policy action by most of the leading industrial nations and theresultant excessive volatility and the markets desperate focus upon historically minor indicators for asense of direction. Nevertheless, Ben Bernankes speech at Jackson Hole, Wyoming addressedthose concerns and, in hindsight, will have marked the turning point when investors turned their backson so called safe haven investments and returned to risk assets.

However, growth assumptions have yet to be fully rebased although the OECD and the IMF have led

the way with their recently downgraded 2011 and 2012 expectations, which have also prompted othercommentators to lower their expectations. Nevertheless, these are still too optimistic but will correctover the next 3 6 months. Prospective long-term growth rates in the US, UK andurozone are likelyto be considerably less than historic trend rates while fiscal imbalances are corrected. Japansdownward step change in GDP growth between 1986 1996 and 1997 2007 provides an indicationof the delta of change that may occur [see Table: Real GDP (YoY % Change)].

Moreover, China and other developing economies will also exhibit a somewhat slower trend growthrate because their domestic economies are relatively immature and over reliant upon the developedindustrial economies for growth.

This slower prospective global growth trend eventually will manifest itself in lower corporate earnings,which for now are still benefiting from earlier carry momentum from the recessions now rapidlydecelerating recovery phase that is wrong-footing equity analysts. Moreover, forward corporateearnings will also be increasingly constrained by capital inefficiency until and unless the globalbanking system is fully repaired and credit growth restored.

Capital markets are generally efficient and although the above broad assumptions have not as yetbeen explicitly imputed into public expectations, these are increasingly being intuitively appliedthrough higher risk assumptions. But it is now only a matter of time before economic realism reassertsitself upon both markets and more importantly politicians.

Therefore, it does not matter whether there is a recession or not but what does matter, is investorshaving confidence in the official data supporting expectations, and if they do, this will permit a quickrebasing of market levels followed by a sustained recovery in investor appetite.

Therefore, tactically investors, in the short term (i.e., next 1 3 months), should be selling (evenshorting) the over inflated and generally illiquid safe haven assets of gold, silver, Swiss francs, etc.and moving into cash (i.e., the more liquid currencies of US$, Sterling, and the uro; the latter onfurther weakness). While in the medium term (i.e., 4 12 months), cash assets should be redeployedinto equities and debt as the forward earnings correction takes place.


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Economic Activity

Leading independent forecasting agencies, such as the IMF and OECD, have confirmed that therecession was considerably deeper and less robust than earlier thought and that the recovery is nowslowing, especially for the major industrial economies.

Unfortunately, these earlier and overly optimistic economic assumptions led to political and fiscalcomplacency, particularly in the urozone, which established the basis for its Sovereign debt crisis.However, market pressure and economic reality are asserting increasingly positive pressure uponpoliticians and very soon aurozone solution will be developed and, more importantly, implemented.

Generally, the underlying cause for the more recent slowing growth rate may be simply thatdeveloped economies are approaching, or have passed, their natural cyclical peaks; the US hasalready recorded 9 consecutive quarterly increases in GDP. This weakening demand from theindustrialised economies is belatedly impacting upon the growth rates of the lesser developedeconomies (such as China, India, Vietnam, etc.) that are further exacerbating their domesticslowdown by using the blunt instrument of interest rates not only to strangle inflation from theireconomies but also starve their property markets of readily accessible credit to deflate a bubble

before it bursts. Unfortunately, their policy decisions are probably too little and coming too late, whichmeans that many Asian economies will suffer very painful hard landings.

Table: Real GDP (YoY % Change)Average Average Average 1997 1998 2006 2007 2008 2009 2010 2011 20121986-96 1997-07 1986-07

France 2.07 2.62 2.35 2.20 3.55 2.42 2.32 0.09 (2.67) 1.38 2.23 2.10Germany 2.61 2.51 2.56 1.85 1.82 3.57 2.78 0.70 (4.67) 3.50 3.44 2.52uro area 2.38 2.85 2.61 2.62 2.76 3.17 2.84 0.31 (4.13) 1.69 2.05 2.01Japan 3.17 0.98 2.07 1.56 (2.05) 2.04 2.36 (1.17) (6.28) 3.97 (0.88) 2.15UK 2.37 3.10 2.73 3.31 3.61 2.79 2.68 (0.07) (4.87) 1.25 1.38 1.83USA 2.90 3.36 3.13 4.46 4.36 2.67 1.95 0.00 (2.63) 2.85 2.57 3.12Total OECD 2.85 3.07 2.96 3.68 2.72 3.15 2.72 0.32 (3.51) 2.93 2.33 2.84

Source: OECD

UK

The UK addressed its budget deficit issue early but only because of a change in Government. Theresponse was calculated and pragmatic and as such preserved the UKs AAA rating while deflectingattention elsewhere. However, the assumptions supporting an elimination of the budget deficit withinone 5-year parliamentary term were overly optimistic. This means that the Government, if it is to keepthe markets onside, has no choice ahead of an election in 2015 but to vigorously persue itscommitment to shrink the public sector. However, it will need to either get its message across that theprocess will take longer to deliver due to weaker economic growth or grasp the poltical thistle anddrastically squeeze the sacred cow budgets (e.g., NHS) from the start of the next tax yearcommencing 6 April 2012. In light of the current anaemic growth, this latter option may be toopolitically difficult, particularly as the real and major spending cutbacks occur during that fiscal yearand unemployment rates will be soaring again.

urozone

Remaining closer to the UK (i.e., EU), the urozones, but particularly the uropean Central Banks(ECB), muddled policy decisions similarly appear to have been based upon overly optimisticassumptions concerning the strength and shape of the recovery leg of the recession, i.e., V-shapedand, more recently, talk of W-shaped. Indeed, Greece has confirmed that its austerity budget wasbased on more optimistic assumptions and that their recession was deeper than previously estimated.While the more recent lack of political resolve has more to do with politicians looking ahead tolooming elections (2012 13) rather than properly addressing immediate economic issues, whichhas created and exacerbated the Sovereign debt crises within the region. Whether they like it or not,

urozone politicians will be fighting their next elections on strong economic management and a


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commitment to eliminate budget deficits than tax give aways, which has already begun to emerge inFrance.

As a brief aside, and bankers at the uropean Central Bank and theirurozone politicians should takenote that theuro could be likened to a Mk III version of the Gold Standard. The much cherished andwell respected Mk I Gold Standard was managed and regulated by the worlds oldest and mostrespected central bank, the Bank of England, until the start of the First World War. The ill-fated Mk IIGold Standard was introduced after the First World War and was regulated by a newly constituted USFederal Reserve because the war had left the UK severely debilitated and its gold reservessignificantly depleted while the US was, as is now, the worlds largest economy. However, the Fedmade a succession of policy errors during the 1920s and 1930s that cumulatively led to the GreatDepression.

Interestingly, the ECB and their political masters because of Germanys inflation paranoia havealready made some similar errors! urozone politicians and the ECB bankers should take greaterheed of what Bernanke and the Fed has, and are doing, otherwise the consequences will becatastrophic for theurozone domestic economies.

Nevertheless, a workingurozone solution will more likely be found but it is likely to result in a changein the political landscape of each of the member nations concerned from but from which will emergestronger economies anduro as these nations become more closely aligned to the German economiccycle.

US

The US embraced an expansionary domestic policy that was also more internationally supportive inapproach than it may have been credited because of the Feds reasonable fear of creating thedomestic and global conditions for another depression through inadequate and incorrect policyresponses. The Fed Chairman, Ben Bernanke, as an economist majored on the Great Depressionand as a result of his extensive research is an advocate that it is better to over stimulate than not Thelatest Bank of England Quarterly report stated that the UKs 200bn QE (Quantitative Easing)programme that began in early 2009 probably stimulated real GDP by 1.5% - 2.0%, which wasbroadly equivalent to a further cut in interest rates of 1.5% - 3%; by implication, the US economyshould have received a comparably proportionate stimulus because of its two QE programmes.

Currently, Bernanke, along with his fellow Fed Governors are watching not only the domestic but theglobal economy, especially those of the urozone and China. However, should the US economyrequire further stimulus this will be forthcoming, most probably in the form of a QE3 although the Fedwill not be rushing to inject too much inflation into the economy. Also, we believe that any expansionof this accommodative approach will be conditional upon a more demanding but long termGovernment commitment to a demanding budget deficit rebalancing programme whether thepoliticians of all parties on Capitol Hill like it or not.

Nevertheless, the Fed is taking deliberate and progressive actions to build a robust platform for asustainable long-term recovery for which it is not yet being credited. For example, marketcommentators have chosen to miss the relevance of the US$400bn Operation Twist. This has beenimplemented to flatten the yield curve, which supports not only an earlier Fed commitment to lowshort-term interest rates but establish the necessary conditions to support a revival of the propertycredit market.

In summary, our view remains unchanged - the global economic recovery will be l or Nike tick-shaped (i.e., a long and slow recovery) while the fiscal imbalances in the leading economies arefinally and specifically addressed. Moreover, this corrective period, at least 10 years, will result in thetrend GDP growth rate falling well below that of earlier periods, which implies lower corporateearnings growth.


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Interest Rates

The overall trend will be downward where there is scope and unchanged where there is none. In theUK, the bank rate is likely to remain unchanged at 0.5% for at least the next 12, possibly 24 monthsand we would not rule out a UK twist programme to provide support to the property market. The Fed

has already indicated that US rates will remain low for at least another couple of years due to thefragility of the economy and possibly longer because of its twist programme. The ECB will shortlybegin to reverse its ill-conceived earlier rises that have exacerbated the issues for the problematicurozone states. Moreover, we anticipate that the ECB and EFSF will co-ordinate supportiveprogrammes to assist urozone states through their painful long-term budget deficit reductionprogrammes.

Table: Official Interest RatesCountry Rate Current Since Last -1 Month -1 Year

US Fed Funds 0.00% 0.25% 16/12/2008 1.00% 0.00% - 0.25% 0.00% - 0.25%US Prime 3.25% 16/12/2008 4.00% 3.25% 3.25%UK Repo 0.50% 5/3/2009 1.00% 0.50% 0.50%uro Repo 1.50% 7/7/2011 1.25% 1.00% 1.00%

Japan Overnight Call 0.00% - 0.10% 5/10/2010 0.10% 0.10% 0.10%Switzerland Libor target 0.00% - 0.25% 3/8/2011 0.00% - 0.75% 0.00% - 0.75% 0.00% - 0.75%Source: ThomsonReuters

Exchange Rates

Exchange rates are perceived to be difficult to predict, which may be true for traders who areexecuting against short-term movements and attempting to interpret daily market noise to finessetrades. However, macro and global investors recognise that exchange rates are a relative reflection ofthe discounted perception of an economys strength and fiscal and monetary management, even if thecurrency is pegged to another.

However, given that most industrialised economies are all broadly in the same place and that trendGDP growth rates are likely to adjust by the broadly similar deltas, then it should come as no surprisethat we are not materially changing our forecasts.

Last December 2010, we forecast that the /US$ would average $1.60 for 2011 but there could bebrief excursions out to the extremes of 1.35 and 1.75. The only adjustment we would make here is totighten up on the 1.35 part of the range and close this down to 1.50. In the case of the /uro, ourview is, this will average 1.15 compared with an earlier expectation of 1.20; the wider trading rangenow appears, in rounded terms, to be 1.08 to 1.20 at the extremes. Moreover, we maintain our earlieropinion that the uro will emerge from this recession a stronger currency a bold call, given currentcircumstances.

We previously did not look at the US$/uro but it looks as though it could average 1.43 for 2011 butwith a wide trading range of 1.35 1.50 at the extremes. While the US$/en could close the yearback up around 80 although, more recently, the US$ and en appear to be tracking each other at thecurrent level.


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Chart: Currencies / US$ / uro

US$ / uro US$ / en

Source: Digitallook.com

Commodities

Oil

Oil prices, irrespective of grade, extended the Q4 2010 rally and surged to a peak during Q2 2011,from which it has been progressively edging lower. The uncertainty created by the Arab Spring canlargely account for this surge but as the year progressed it became clearer that underlying demandcould not justifiably sustain the inflated levels. Moreover, major producers increased output tocompensate for any temporary supply shortfalls and those producers will trim back their output as theaffected offline producers go back online and so maintain the supply/demand balance.

It should not be forgotten that OPEC has previously declared that an oil price trading between $70

and $90 per barrel was sustainable and its members, led by Saudi Arabia, have been managingsupply to maintain that range. In terms of pricing, their balanced supply policy worked verysuccessfully from broadly the end of Q2 2009 to the opening weeks of 2011. Thereafter, speculativetraders drove the price to the 11

thApril 2011 peak of $127.02 per barrel. However, slowing global

demand together with a progressive easing of North African tensions following the regime changeshas started to exert normal pricing discipline upon this commodity and prices have been steadilydeclining and we anticipate that this trend will be sustained until oil returns to the $70 - $90 range.


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Chart: Oil


Gold

When we wrote our report last December, we stated that gold (and other commodities) would bethe highlight of this year but that the run was a final blowout. However, our view is that thegold bull run is heading into its final blow out, probably sometime within the next 3 9 months.The final blow out, depending upon momentum, may add another US$100 US$300 to currentprices at best (US$1,388.50). While on 2nd September 2011 on CNBCs Investing Edgeprogramme, we advised selling gold and other safe haven assets and look to deploy the proceedsinto risk assets; (click on following link to see the video:http://video.cnbc.com/gallery/?video=3000043534).

Our timing was just about right and only missed a slither in percentage points from the top butthen only the very lucky ever call the precise top or bottom of a run!

Gold and other perceived safe haven commodities, such as silver and more recently platinum andpalladium (both of which are more generally influenced by automotive demand), have all begun tofall sharply although not exhibiting a bursting bubble, which suggests a controlled exit rather thana rush to the door. We believe that investors are implementing a tactical shift in asset allocationback into cash or more precisely near cash instruments, such as short dated US governmentdebt.
http://video.cnbc.com/gallery/?video=3000043534http://video.cnbc.com/gallery/?video=3000043534http://video.cnbc.com/gallery/?video=3000043534


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Charts: Gold, Silver, Platinum and PalladiumGold Silver

Platinum Palladium


Debt Capital Markets

The debt market has endured a turbulent period since the global economy began to recover from therecession. But as the dust has settled, investors have been increasingly horrified by the severity of thedamage to the financial system and the scale of the imbalances that need correcting, which hasresulted in an almost wholesale reappraisal of credit ratings for all borrowers.

Proactive borrowers, such as the UK Government, for now, have fared considerably better than thestartled political rabbits within the urozone. While the US, which responded rapidly to shore up and,more importantly, lay down solid foundations for a sustained long-term recovery were punished with acredit downgrade because of the stupid political bickering on Capitol Hill.

Nevertheless, there is a growing realisation that the major industrial economies are finally getting on

top of, rather than fire-fighting, issues. And, once the debt capital markets can direct capitaleconomically toward industrial applications rather than for the competitive refinancing of governmentsand financial institutions then the global growth engine will begin to build up momentum and reopenthe M&A cash market. Nevertheless, we anticipate increasing demand across all debt asset classesas investors reallocate long-term capital back into risk assets.


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Charts: Yield CurvesUS Yield Curve

UK Yield Curve

uro Yield Curve

Japan Yield Curve

Source: www.ft.com


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Equity Capital Markets

The media and short-term traders are fuelling an unnecessary frenzy about the possibility of a doubledip recession. Yes the globally economy is slowing but there are several reasons and all are beingaddressed, admittedly in some areas naively, by policy makers.

Do we believe the world and, more particularly the urozone, will re-enter recession? On balance no,but it will be very close.

Global economies are all naturally slowing from the heady recovery phase of the synchronised globalrecession, an effect that was expected once the supply pipeline had refilled. However, demand isbeing more heavily dampened, particularly in the industrialised economies due to the cumulativeimpacts arising from rebalancing and shrinking the public or state sector. While the lesser developedeconomies, which remain overly dependent upon the increasingly sluggish industrialised economies,are chilling their economies to simultaneously squeeze out inflation while desperately deflating assetbubbles that have arisen due to cheap credit seepage from earlier western QE programmes.

More importantly, governments and investors have been wrong-footed about the depth of therecession as well as the shape of the recovery. This has been compounded by the frequentdowngrades to growth expectations, which have created uncertainty and undermined confidence inthe underlying data. We re-iterate our earlier and long held view that the recovery will be long and

anaemic (i.e., resembling an l).However, economists and forecasters are finally reaching their capitulation point and growthexpectations will be cut to believable and achievable levels. While the banking industry, althoughfinancially stronger than when it entered the last recession, remains over extended and as a resultcontinues to either refinance, shrink balance sheets or combinations of both. Until this process hasbeen completed, credit will be restricted at a time when greater availability would be helpful.

However, once markets fully adjust for the new low growth era and become less volatile, this calmerenvironment should encourage industry to again start investing for growth, which will encourageinvestors to further direct increasing levels of capital into all classes of cash equities. In turn, this willfeed into corporate earnings expectations (i.e., a step change down) although, due to earlier recoverymomentum, earnings will appear surprisingly robust. But this is no more than a timing issue and thereare signs that this process is already underway. Once it does, equity markets will undergo a stepchange to fully discount the lower trend rate.


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Charts: IndicesWorld

FTSE100

DJ Industrial

Source: www.ft.com


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Charts: Indices (continued)FTSE Eurofirst 300

Nikkei 225

Shanghai SE Composite

Source: www.ft.com


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Conclusion

The dust is finally settling following the ending of the 2008 2010 synchronised global recession andeconomic clarity (and reality!) re-emerging. In turn, this is resulting in a tactical reallocation of assets.Capital is shifting from the generally illiquid safe haven assets (e.g., gold, silver, Swiss Franc) and

initially transiting into highly liquid cash pools of cash (e.g., short-dated US government debt) beforebeing redeployed into cash equities and long-term debt. However, the pace of the tactical reallocationwill be a function of rebuilding confidence in official data as well as the effective implementation ofdomestic fiscal policies but not whether there is a recession, which is no more than a market re-entrylevel. This final downward step change in global economic growth rates will result in a knee jerkadjustment to long-term corporate earnings expectations. But this new realism will enable corporatesto plan for a resumption of growth, which will restart their capital investment programmes and M&Athat in turn will lay the foundations for a sustainable IPO market.

Philip Morrish ([email protected])

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Tide Has Turned in Favour of Risk 06102011