IPA Q1 2009 - Recessions and financial crises are inevitably greeted with apocalyptic headlines, heralding a new Ice Age and an economic outlook similar to the 1930s. Today’s ubiquitous gloom is manifest in the almost unanimous preference for sovereign fixed income trades, with only a few brave souls willing to tread even an inch out the risk curve or breathe a kind word about equities. With the consensus so clearly favouring ‘deflationary’ trades it is an opportune moment to ask “How many times does the end of the world as we know it need to arrive before we realise that it’s not the end of the world as we know it?” (from “Panic: The Story of Modern Financial Insanity” by Michael Lewis).
To be clear, we are in the middle of a severe recession, a V-shaped recovery is out of the question, and today’s slump could conceivably mutate into a deep and prolonged downturn. However, depression and deflation are ‘tail’ risks and should not constitute an investor’s base case scenario. Rather, 2009 is likely to be a transition year, from today’s deflationary environment to 2010’s reflationary setting. Although it remains too early to rush out the risk curve, the pertinent questions are: what signposts will help us recognize when to switch from ‘deflationary’ to ‘reflationary’ trades; and what trades should we be considering?
However, first we need to clarify why a 1930’s-style depression is unlikely? The key reason is the dramatic policy response that has been unleashed in almost all major economies. Global fiscal stimulus is set to come in at 1.5% of world GDP in 2009, led by President-Elect Obama’s ‘shock and awe’ package, as well as China’s super-sized measures. Further, central bankers globally, many taking their cue from the hyper-active Fed, have cut rates aggressively and been remarkably creative. The policy responses elicited by the current recession could not look more different than the timid and ambivalent programs evoked globally in the ’30s, or by Japan in the ’90s.
That said, the current US recession, which is already well into its thirteenth month, is undoubtedly one for the history books. Even given our relatively optimistic expectation that growth will bottom in Q3 of ’09, this is prone to become the longest downturn since the ’30s (the mid-70s and early-80s recessions both persisted for 16 months). If the numerous bears are correct and growth flounders until Q1 of 2010, then it is liable to become the second longest since the 1880s. Over the last 125 years only one recession has lasted longer than twenty-four months and today’s slump, however severe and painful, bears at best a faint resemblance to it.
For how much longer will deflationary strains remain dominant? We expect that countervailing forces, driven by reflationary monetary and fiscal policies, will be successful in restarting credit markets within the next two or three quarters. The key signposts to monitor regarding this transition include: a significant narrowing of spreads for inter-bank, mortgage and corporate credit; an inflection point in manufacturing PMIs (those for the US, Europe, Japan and China are now more than three standard deviations below normal); and a slowing pace of US home price declines. Monitoring signposts in a disciplined manner is critical because market timing is notoriously difficult, partially because a very small number of days represent a disproportionate share of returns.
The current deflationary environment has generated some compelling investment opportunities (it would be astonishing if a five-fold spike in volatility did not), particularly as the market rotates towards ‘reflationary’ trades? Starting with equities, a host of markets look inviting, including the HSCEI (Chinese H-Shares), the UK and Australia, all of which feature energetic domestic policy responses and attractive valuations. Further, note that the S&P 500 usually begins to recover three to six months prior to growth bottoming. It has already declined by 44%, or by 51% at its Nov. 20 trough, which counts as the worst print since the ’30s. While not our favourite equity market, history suggests 10% further downside risk, with appreciable upside.
Regarding fixed income, although not reflationary trades, the very short-end of the Brazilian, Mexican, Korean and New Zealand markets are attractive, as economic growth is plummeting (as it is everywhere), but their central banks have not yet cut aggressively enough (or not at all in the cases of Brazil and Mexico). While G10 2-year and 10-year sovereign yields have already come in dramatically (too much so in most cases), some value remains in markets like Gilts. US markets present numerous opportunities, including TIPS (negative Break Even inflation) and mortgage-related securities (as policy makers focus on narrowing spreads). Further, US high grade corporates present a compelling case (given their excessively high implied default rates), either as a directional trade or pair-wise against Treasuries or equities.
As the torch passes from the U.S. dollar and Japanese Yen, currency trades are more challenging to assess. While it is difficult to be constructive on the Euro or Pound, a case can be made for the Australian Dollar (especially against the Canadian Dollar or the JPY). As a pair-wise basket trade, many Asian currencies look attractive against their east European counterparts, most of which possess very high debt levels, much denominated in foreign currencies, and shaky banking systems.
Some of these trades may appear brave or even foolhardy in the current environment. Indeed, it is difficult to think about reflationary trades when newspaper headlines are unequivocally bearish, sentiment is at rock bottom, and many of the world’s top investors are smarting two black eyes. This year will be terrible in macro terms; no-one is debating that. However, the critical question is: has the market’s indiscriminate flight to safety left some asset classes compellingly valued, and when is that value likely to be realized?