The late economics professor, Hyman Minsky, once wryly observed that, “There is nothing wrong with the state of economics that another depression won’t cure.” Lamentably and inexplicably, it appears the current financial crisis has not been sufficiently traumatising for central bankers, economists and investors, many of whom naively believe it is back to business as usual.
It seems that almost every remaining market bear, after returning to the office post-Labour Day, has decided it’s time to throw in the towel. Further, many if not most major banks are now asserting that, with rates at historical lows, and no fear of change in policy any time soon, markets are in a “sweet spot” that may last for several more quarters. This is a perplexing development and suggests a poor comprehension of market history.
To my eye a particularly difficult phase of this cycle looms, one involving a delicate balancing act. While today’s monetary conditions are loose beyond precedent, if normalized too quickly, a double-dip recession will undoubtedly result. However, if excess liquidity is left in place for too long, the stage will be set for resurgent inflation and yet another asset bubble.
Sweet spot aficionados presume rate hikes are a long way off. To understand their logic let’s consider the Fed, where the arguments to procrastinate appear particularly compelling. Headline CPI is running at -1.5% yoy; the output gap is gargantuan; the credit creation process moribund (consumer credit is down 10% yoy, while commercial and industrial loans have shrunk by 7% yoy). And Ben Bernanke is the world’s foremost expert on Depression-era monetary policy, including the disastrous 1937 tightening. This all suggests a Fed that is apt to err on the side of loose policy, with the first hike due in Q3 of 2010.
The problem with this argument is that the market, like nature, abhors a vacuum. Even if the Fed and other G4 central banks don’t hike for another couple of quarters, expectations will be anything but steadfast. One specific catalyst can be used to illustrate this point. By November 18 (when US October CPI data is released) markets are prone to suffer from serious sticker shock. US headline CPI printed -0.8% mom in October 2008, followed by -1.7% in Nov and -0.8% in Dec. As these base months drop off the yoy calculations, headline CPI will be boosted by an eye-popping 3.3 ppts and policy expectations will indubitably surge.
Inflation sticker shock will make headlines for several months and provide plenty of ammo to: (a) policy hawks, including at least two Fed voting members who are already positioning for a hike; (b) Fed critics, especially those who, incorrectly, attribute to the Fed primary blame for the housing bubble and; (c) conspiracy theorists, who erroneously fear motivations to inflate away the growing mountain of Treasury debt (which rolls over too frequently for such a strategy to be effective).
Base effects are of particular concern for the US, given its weak currency and the inevitability of import price inflation, but will also be writing headlines in the UK, Europe, Canada, and so on. For example, by January UK inflation will likely be temporarily boosted to over 3%, requiring the BoE’s Governor to write yet another letter to the Chancellor explaining how he plans to return CPI back to target
Some investors might argue that base effects due to oil’s plunge last autumn are ephemeral and, as such, markets will look through them. Possibly, but the evidence is not encouraging. Historically, rate hikes have almost always been bad news for equities in particular, and risk assets in general. Further, and more recently, Chinese A-shares fell by over 20% in August on mere rumors of policies to curtail loan growth. Maybe this time will be different, but I suspect not.
Consequently, rather than lasting several more quarters, the sweet spot is assuredly in its final days. The subsequent three months will be quite bumpy, as central banks attempt to clarify how they will time and sequence their exit strategies. In this spirit, Treasury Secretary Geithner recently cautioned that the recovery will have “more than the usual ups and downs.
Our expectation is that the first set of countries to tighten will include: China, Norway, Australia, and South Korea, followed in short order by Taiwan, Indonesia and Mexico. We look for the next set to consist of: Canada, Sweden, the ECB, the US and the UK, followed by Switzerland, New Zealand, Malaysia, and Brazil. Regrettably, Japan remains in a league of its own, with decrepit domestic demand, and deflationary forces firmly rooted.
What type of strategy should investors follow in this type of environment? Let’s start with the most promising asset class, FX. To a large extent, currency strategy involves going long early tighteners, while shorting the laggards: long the RMB, NOK, AUD, KRW, TWD and MXN against the CHF, USD, GBP and JPY.
Fixed income strategy entails a large duration underweight, as there is little value to be found in this asset class (aside from selective credit and swap trades). On the other hand, commodities as a group possess room to run much further. Several energy sectors are attractive, as are industrial metals, particularly Zinc, which is normally conspicuously cyclical but has lagged this year.
The toughest asset class is equities, which to a large extent is fully valued, and liable to be severely buffeted by the forces discussed above. In such an environment earnings growth is paramount, leading us to favour Asian equities (we expect 30% EPS growth in 2010), especially Korea (forward PER of 10x, undervalued KRW) and H-shares.
Niels Bohr defined an expert as “a person who has made all the mistakes that can be made in a very narrow field.” While he was presumably referring to physicists, the epitaph fits central bankers, economists and investors equally well. Sadly though, we seem to have much flatter learning curves than physicists (maybe because they are so much smarter) and appear determined to demonstrate to the world over the next few quarters that there are lots of mistakes we have not yet made. For those somewhat more cognizant of financial market history, this should translate into some compelling investment opportunities, especially in FX markets.