IPA Q2 - Chuck Yeager and the Mercury 7 astronauts, as immortalised in Tom Wolfe’s novel based on the US Space program, undoubtedly had the “Right Stuff”. This was particularly true of Yeager, the first pilot with the audacity to break the sound barrier (with two broken ribs no less), who Wolfe uses to personify the many post-war test pilots who helped the US overcome a crisis of confidence, coming from behind to beat the USSR in the space race.
While certainly less dramatic than riding atop rockets with a proclivity to explode, the current crisis has not been without its perils and blowups. It has left investors waiting and hoping for US policy makers to come through and exhibit the Right Stuff. If they don’t, there is a significant risk that growth will continue to implode - a scary scenario given that we are already experiencing the first decline in global economic activity since World War II. As Chairman Bernanke recently emphasised, in a highly effective prime time TV interview, the biggest risk to a recovery is not a lack of economic tools, but a shortage of “political will.”
This sounds eerily familiar, especially given that I spent most of the 1990s working in Tokyo, where a depressingly long list of politicians and bureaucrats “never missed an opportunity to miss an opportunity”. It is now widely known and accepted that inept macro policy condemned Japan to a decade of deflation. However, as Ben Bernanke noted, it was “political constraints, rather than a lack of policy instruments, that explain why Japan’s deflation persisted for as long as it did.”
Regrettably, political will was in short supply for over a decade. Japan’s luck finally changed in 2001 when PM Koizumi, together with his key ally and policymaker, Heizo Takenaka, demonstrated the acumen and audacity to fix the banking sector. Their acumen involved understanding the critical steps required to resolve the financial crisis: aggressive monetary and fiscal policy, rapid disposal of troubled assets, recapitalisation of the banking system, and the introduction of a new regulatory structure. Their audacity involved circumventing the cumbersome political process and taking on their own party (recall Koizumi’s slogan, “Change the LDP, Change Japan”), largely by communicating their message directly to the electorate (Takenaka became something of a rare bird - both a world-class economist and a TV celebrity).
Fast-forwarding to 2009, how confident can investors be that US policy makers possess the acumen and audacity to solve the current crisis? While Chairman Bernanke deserves a resounding vote of confidence, Congress deserves nothing but deep skepticism (during this crisis they have placed politics firmly ahead of policy). That leaves Treasury Secretary Geithner, who falls somewhere in between the two extremes.
Lamentably, there are three reasons why it is unlikely that Geithner’s Treasury will surprise on the upside during 2009. First, he remains the Treasury Department’s only Senate-confirmed official, with seventeen other top positions still vacant. Capable candidates have been discouraged by “vetting hell” (according to the FT, one nominee was asked about his wife’s sexual activity while she was at university, while a second was asked to produce receipts for furniture donated a decade ago) and the cloud over anyone with Wall Street experience. Second, five months after its announcement, there remains little to no consensus on how to implement the highly controversial TARP. The only things certain are that decisions will be highly political (worrisome in the current toxic environment) and that the implementation timetable will be glacial. Third, hedge funds and other investors are hesitant to participate in the TALF, or Public-Private Investment Fund programs, because of legitimate concerns that the government will retroactively change the rules of the game, ensuring a heads-you-win, tails-I-lose contest.
In light of this rather pessimistic outlook for US policy, how might investors position their portfolios? Regarding currencies, the key theme is to short countries with extremely loose monetary policy, which suggests long EUR/CHF, AUD/CAD, NOK/USD and RMB/JPY. Concerning fixed income, an overall long duration position is likely still called for (inflation is next year’s problem), as there remains value in the short end of the yield curve in the UK, Brazil, Mexico, Korea, and NZ, as well as the long end in the UK and Germany. Credit remains a difficult call, as valuations are compelling, but liquidity will remain tight until the banking system is fixed. Similar comments apply to equities, where positioning should be relatively cautious, with little overall equity beta. It is likely preferable to emphasize pair-trades such as long Chinese H-shares (attractive valuations, aggressive policy response, rebounding domestic demand) against Japan, and long Brazil against S. Africa, with a modest overweight to emerging markets in Asia and Latam.
What catalyst could encourage investors to move further out the risk curve? For many pundits the key is an inflection point in high frequency indicators such as PMIs, confidence measures, industrial production and exports. The good news is that this appears to be occurring already, with second derivatives turning positive in China, Australia, the US, and several others. Bulls note that the consensus forecast is for the US recession to end by late-Summer, with 2010 exhibiting solid, trend-like growth of 2.8%. The bad news is that any upturn in growth is likely to be short-lived unless the US banking system has returned to health, and that seems highly unlikely to occur this year.
What would need to happen for US policymakers to surprise markets on the upside, proving the many pessimists wrong? In the case of Japan, the surprise occurred when Koizumi and Takenaka demonstrated the acumen and audacity to fix a decade-old banking crisis. There certainly are US policymakers with the requisite acumen, as Chairman Bernanke has repeatedly confirmed. However, only one person possesses the ability and audacity to take the initiative from Congress and communicate directly to the electorate. Investors will know the tide has truly turned, and that it is time to move decisively out the risk curve, when President Obama steps up and demonstrates that he indeed possesses the Right Stuff.