Handoffs are always a tricky business. My oldest daughter runs on her high school track team and is so nervous about flubbing the relay handoff that she’ll stand patiently waiting until the baton is placed firmly in her grip before striding away. While running does not rank among his many accomplishments, Fed Chairman Bernanke also has good reason to be nervous about what he calls the “critical handoff”.
Last month Chairman Bernanke gave the opening speech at the annual Federal Reserve retreat in majestic Jackson Hole. He emphasised that, while fiscal stimulus and inventory restocking have so far driven the economic recovery, a sustained expansion is only possible following a successful handoff to the consumer. This depends to a large degree on the labour market which, as he acknowledged, has thus far exhibited a disappointing and “painfully slow recovery”. Regardless, Bernanke concluded by optimistically asserting that “Despite the weaker data seen recently, the pre-conditions for a pickup in growth in 2011 appear to remain in place.”
While Bernanke may be confident that this is a garden-variety recovery and that a deft handoff is imminent, his views were not shared by the second speaker at Jackson Hole, Carmen Reinhart, a preeminent authority on the history of financial crises. Her analysis strongly suggests that “this time is different” and that the American economy will continue to experience tortuously slow growth and stubbornly high unemployment as consumers reduce their debt levels. Given that this de-leveraging process started roughly three years ago and, on average lasts 7 years, a robust consumer-led recovery might not materialise until 2014.
Professor Reinhart’s research suggests that the US labour market could remain sluggish for a further four years, while Chairman Bernanke contends that a revival is just around the corner. For three reasons we believe the truth likely lies somewhere between these two views, but somewhat closer to the pessimistic professor’s.
First, the mean US savings rate was 8% in the 25 years to 1994, but since then has averaged only 3.8% (and less than 2% during the peak housing bubble years). From late-2007 consumers started to rebuild their balance sheets and, accordingly, increased their savings rate to 5.9%. Morgan Stanley estimates that this rather modest deleveraging reduced 2009 GDP by 2.0 ppts, and that further increases in the savings rate would ensure a strong growth headwind for at least another three years.
Second, of the eleven post-WWII recessions, the 2007 - 2009 period was by far the worst in terms of percentage job losses relative to peak employment (6.1% versus, for example, 2.0% in 2001 and 1.4% in 1990). If employment rebounds at the same rate it did in the two previous recessions, it will take three years to eliminate today’s huge and deflationary output gap.
Third, a bottom-up analysis of the labour market provides little reason for optimism. Of the seven employment categories that normally lead labour market rebounds, three have rallied solidly in 2010 and should continue to do well (temp help, transportation, health care), while three others are acting counter to cyclical norms and continue to shed jobs (construction, restaurants, professional & business services). The seventh sector, manufacturing, is enjoying its best post-recession bounce in fifty years, but is in secular decline and possesses little additional upside from here.
Further, three categories that normally lag the recovery (finance, state & local government, retail), will likely follow historical norms and continue to shed jobs. While there exists potential for upside surprises (e.g., in the retail and restaurant industries), a bottom-up perspective highlights the structural weakness in sectors such as construction, finance, and state & local government, making it difficult to see a labour market revival happening any time soon.
Is the “critical handoff” just around the corner as Chairman Bernanke asserts, or four years down the road as Professor Reinhart attests? At this point conventional cyclical indicators (e.g., PMIs, industrial production, employment, retail sales) are sending unusually mixed and choppy signals, implying that this is not the time to be a hero by moving significantly out the risk curve. In that case, what type of investment strategy should investors adopt?
Regarding equities, investors might consider taking only a modest amount of long equity beta, saving their focus and risk-budget for pair-trades. For example, taking long positions in emerging markets that possess sound balance sheets and strong domestic demand growth (e.g., China, Indonesia, Korea and Brazil) against developed markets that are still in the early stages of the deleveraging cycle (e.g., the US, UK, and the PIIGS). Another possible pair-trade involves going long Germany and Switzerland vs. Japan.
Concerning fixed income, investors could consider two strategies. First, even though current G10 bond yields are only defensible if Professor Reinhart is correct, taking too large a short duration bet is overly risky. A better approach may be to take advantage of low implied volatilities and buy long-dated puts on 5Y or 10Y bonds. Second, focus on pair-trades such as long US vs short Canada, long France against Sweden, Japan vs Switzerland, and NZ against Australia.
The key theme for FX strategy echoes that for equities. Take long positions in a basket of emerging markets with solid finances and robust domestic demand (e.g., RMB, KRW, BRL), against developed markets that are still in the early stages of the deleveraging cycle (e.g., USD, GBP). A final trade worth considering is going long the CHF against the JPY.
An investment strategy that emphasises a large number of pair-trades rather than a small number of directional bets might sound overly cautious. However, I remain nervous about the “critical handoff” and, similar to my daughter and her relay team, want to feel the baton placed firmly in my hand before striding away. Better to be sure and loose a few seconds, then to flub the handoff and loose the whole race.
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