Outlook 2010: Black Swans or Black Sloths?
At the end of every year, Martin Barnes of BCA Research puts together the outlook for the following year. This is an excellent publication and I advise all institutional clients to read it thoroughly. You can obtain a copy of BCA's Outlook 2010, The Debt Supercycle Goes Global, by clicking here.
For my Outlook 2010, I decided to follow the BCA style this year, except I do not have a client called Mr. X, but will rather have someone called Mr. Y who asks me, the editor, a bunch of questions on the global economy and the markets. I will provide hyperlinks to the numerous articles cited, and will focus on the major themes. Hope you enjoy reading this comment.
Mr. Y: You are up vey early this Saturday morning.
Editor: Yes, couldn't sleep properly because I have severe upper back pain. So I decided to get up and start writing my Outlook 2010, which is the one post I dread to write every year.
Mr. Y: Why so? I thought you liked writing it.
Editor: I love researching it; writing it not so much. It takes a lot of reading, a lot of thought, and to be honest, a lot of energy. But it's important so let's not waste any more time and get right to it. Please fire away.
Mr. Y: Fine, let's begin with the global economy. Cody Willard wrote a comment for MarketWatch, Economic Outlook 2010: First, bet on the OECD being wrong again, where he basically ridicules OECD projections and concludes by stating: "Expect price inflation but not asset appreciation. There’s a difference, even if the OECD’s economists don’t see it." Do you agree with Mr. Willard?
Editor: Not entirely. First of all, it wasn't just the OECD that totally missed forecasting the last financial crisis. I know of many venerable institutional funds that got their heads handed to them. Second, given the unprecedented liquidity in the financial system, I expect more bubble trouble in 2010. There is considerable slack in the global economy, so I am not convinced that inflation will come roaring back any time soon. You will likely see a cyclical backup in yields as the US economy recovers, but not the runaway inflation we had in the 1970s.
Mr. Y: Let's come back to the issue of asset prices a little later and focus on the economy right now. In August 2008, you wrote about Galton's Fallacy and the Myth of Decoupling where you cited Desmond Lachman of the American Enterprise Institute. Do you still hold the view that the US is the engine of global economic growth?
Editor: Absolutely. While there is no question that a secular shift is going on in the BRIC economies and that China and India will play an increasingly more important role in the world over the next decades, the US remains the strongest economy in the world and without a US recovery, it's silly to discuss the prospects of a sustainable global recovery.
Mr. Y: On the issue of China, Gavekal’s Arthur Kroeber, recently wrote that there is no doubt the Chinese economy is overheating and policymakers remain behind the curve. What do you think?Can China halt its building bubbles?
Editor: I am not convinced of these "China is overheating" arguments. In early December, I had lunch with Keith Porter who used to manage the Emerging Markets portfolio at the Caisse. I wrote about it in my post on the rally of a lifetime. Anyways, Keith made a very intelligent argument, stating that what we Westerners perceive as "overinvestment", might be totally false when it comes to China.
Importantly, Keith thinks that all this talk of excess capacity in China is missing the bigger picture. He told me that China is planning and preparing for the future so they have every reason to overinvest now and build up their infrastructure and stockpile the resources. It makes perfect sense when you think about it. They saw all the mistakes the Western world made and decided it's best to be better prepared for the future.
Moreover, I agree with Jeff Nielson who made a comment on Seeking Alpha in early November, There's No Bubble in China. Mr. Nielson wrote the following:
Having dealt with definition of terms, let's look at the facts of the Chinese economy. First, there are vast levels of savings in the Chinese economy. It was because of the vast amount of savings in the Japanese economy that an economic downturn of well over a decade resulted in relatively few bankruptcies and defaults – despite the fact that all the other ingredients of a huge asset-bubble were present.
China's economy is growing much more rapidly than other economies. A growing economy generates real increases in wealth. Rising wealth supports higher asset prices, thus a rapidly growing economy can sustain a much more rapid rate of asset-appreciation.
However, the China-bashers still insist that there is one ingredient of a “bubble” in China: too much leveraged debt, they claim. Given that these same “experts” were totally incapable of spotting excessive leveraged debt in the U.S. economy, it should be of little surprise that once again the experts are totally wrong.
China's four largest banks, which account for nearly half of new loans originated in China this year, have seen their total deposits quadruple while lending has only tripled. It should be obvious even to the inept, China-bashers that if China's biggest banks are taking in $4 of deposits for every $3 dollars that they lend, that they have been getting steadily less-leveraged all year. This is in contrast to the behavior of U.S. banks during the housing bubble (and Wall Street Ponzi-scheme) – where U.S. banks were lending out $30 of debt for every $1 they took in, in deposits. Can you spot a slight difference here in the degree of leverage?
To provide even further assistance in educating the experts, let me introduce them to a real “bubble”: the U.S. bond market. At a time when the U.S. is dumping more supply onto the market than at any time in history, bond prices remain near all-time highs. It is straight out of Economics 101 (presumably the experts managed to pass that course) that when you increase the supply of any good that you depress the price. An extreme increase in supply should result in an extreme decline in price. Thus, the first condition for a bubble is satisfied: a grossly over-valued market.
It is even easier to point out the excessive leverage, because it exists in so many ways. To begin with, the U.S. debt-to-GDP ratio is increasing exponentially – a sure sign of excessive leverage of the U.S. government, by itself. However, there is an even more obvious indicator of excessive leverage: the need for the U.S. government to “buy” much of its own bonds to prop-up the prices. Without any possible doubt, this is the most blatant example of an over-leveraged market on the planet – yet it remains “invisible” to most of the experts (and all the China-bashers).
As a further note, we are seeing very similar behavior in U.S. equity markets, where the Plunge Protection Team permanently pumps-up valuations of U.S. equities through buying-up shares, and in the U.S. housing market – where U.S. banks have also artificially (and radically) reduced supply, through simply holding millions of foreclosed U.S. properties off of the market (see “Fantasy Housing Numbers a Prelude to NEXT U.S. Crash”).
You don't suppose the same group of experts who already totally over-looked one, enormous U.S. asset-bubble could fail to see several more, do you?
Mr. Y: I am glad you mentioned the bond market. Right before Christmas, you wrote that a number of top hedge funds are betting on a big rise in yields. But you're not convinced that yields will explode up. Do you still hold the view that there is no bubble in bonds?
Editor: I repeat what I stated earlier, without a sustainable US recovery, you can't have a meaningful global recovery. While I agree with Mr. Nielson's views on China, I am not worried about a US bond bubble. The Chinese and other investors will continue to purchase US bonds because they will not bite off the hand that feeds them.
What's a bit trickier in the bond market is that investors are underestimating the strength of the nascent US recovery. I think the next few US employment reports will readjust market expectations to the upside. You'll see significant gains in payrolls and substantial upward revisions to previous employment figures.
Mr. Y: How so? Are you being overly optimistic on the employment front?
Editor: There is no doubt in my mind the US economy is recovering. The Conference Board's U.S. Leading Economic Index (LEI) increased for the eighth consecutive month in November. If you look at November ISM New Orders surging above 60, profits before taxes increasing to $157.9 billion in the third quarter, compared with an increase of $90.6 billion in the second quarter, a pick-up in business investment, this all means that firms are ready to hire again. As conditions improve, you'll see more hiring.
But let's be clear on something. More hiring from depressed levels won't make a huge impact on overall consumption as there is still way too much slack in the economy. We know that the real US unemployment rate is closer to 18%, so there are still far too many people that are left behind in this economy.
What will be interesting to see in the first half of 2010 is how the bond market reacts to the increasingly positive jobs reports. Will we get a slight or significant backup in yields? Will the Fed remove excess liquidity slowly or quickly and start raising rates sooner than what the market currently anticipates? If growth starts dissipating in the second half of the year, how will the bond market react to a possible second round of stimulus? Will there be a run on the US dollar as some of the doomsayers are predicting?
Mr. Y: Back in October, you wrote a comment on the death-defying dollar. Given the structural problems, isn't a run on the US dollar a real possibility? Why are you so bullish on the greenback?
Editor: Currency calls are always about relative growth expectations. At this point and time, I see the US economy growing stronger than Japan which just unveiled an ambitious economic growth strategy, or than Europe where Spain just took over EU presidency and vowed to focus on the economy.
At this time, I agree with GaveKal Research that short US dollar positions are increasingly risky as an improvement in economic outlook could unleash a violent reversal of the carry trade, forcing foreign producers to scramble for US dollars as they attempt to meet working capital needs.
Mr. Y: And what about China's currency peg? Won't they have to readjust their peg in light of all this?
Not necessarily. As the US dollar appreciates, so does the Chinese yuan. In late October, I wrote about the Chinese disconnect and agreed with the views of Zachary Karabell and Jason Dean over Krugman's simplistic view that "something must be done about the Chinese currency".
Importantly, there is no more China and America, but Chimerica. The relationship between large US multinationals and China is crucial to understanding the underpinnings of the global economy. It's quite silly to talk about these two economic superpowers separately.
Mr. Y: Let's move on to commodities. According to the IMF, commodity prices were surprisingly buoyant in 2009, and are expected to increase further in 2010 as world activity expands after the global crisis. Do you agree with this view?
Editor: Yes, 2009 was the year of commodities and I think we will see further price gains in 2010. But not all commodities will rise in 2010. Given my views on the US economy and the greenback, I am less bullish on gold and more bullish on oil, copper, natural gas, and wheat.
Mr. Y: How can oil rise along with the US dollar? Also, aren't you worried that a rise in crude prices will hamper the global economic recovery?
Editor: Yes, given the abundant liquidity in the financial system, there is a threat that speculative activity will pick up in energy markets, but I don't agree with those that assume oil above $100 will threaten the recovery. It all depends on how fast we get there and whether or not prices significantly diverge from the underlying fundamentals of the economy.
As far as oil prices rising along with the US dollar, we have seen this in the past. It's all part of the normal cyclical recovery story. I would add that the same goes for stocks. Bears automatically assume that a rise in the US dollar and oil prices will kill the rally in stocks. But they ignore the dynamics underlying the recovery.
Mr. Y: Please explain this because stocks and commodities came off one of their best years ever. In 2009, you talked about liquidity drowning the meaning of inflation, big money suffering performance anxiety, and the recovery mirroring the decline. Surely you are not suggesting the same spectacular gains for 2010?
Editor: Of course not. Risk assets performed exceedingly well in 2009 because last year this time, investors were suffering from irrational pessimism and post-deleveraging blues.
Let me go further and tell you that 2009 was all about beta. Any monkey could have made money being long corporate bonds, stocks, commodities and commodity currencies. That's why I am not impressed when large pension funds like CPPIB come out to boast about their performance, because it really all boils down to the beta boost.
I might add that the same goes for most hedge funds. The ones that survived the crisis and the calls for redemptions did very well in 2009 because most of them also benefited from the beta boost. Going forward, alpha will be the key to making money in these markets. And very few hedge funds or pension funds know how to deliver true alpha, ie. returns above a proper beta benchmark.
Mr. Y: You just mentioned the "B" word, the one that makes senior pension fund managers cringe every time they read your comments. Are you dead set against private equity, real estate, infrastructure commodities and hedge funds as far as proper diversification of pension assets?
Editor: Absolutely not! What troubles me is when I see senior public pension fund managers act stupid, gaming these benchmarks or not even bothering disclosing them!
Importantly, if stakeholders are going to dole out millions in bonus, they better make sure the board of directors at these public pension funds are doing their jobs properly, approving performance benchmarks for all asset classes, especially private markets and internal and external hedge fund activities, that accurately reflect the risks of the underlying investments.
Mr. Y: I can see this is one of your pet peeves. You become visibly angry and have been writing on bogus benchmarks in alternative investments ever since you started Pension Pulse.
Editor: Look, if you're paying hedge fund managers or pension fund managers for alpha, then you'd better make sure they're delivering alpha, not beta. It's quite disconcerting to see the glaring gaps in pension governance when it comes to compensation based on bogus benchmarks that do not reflect the risks of the underlying investments.
While the largest abuses are in private markets (private equity, real estate, and infrastructure), there are abuses too in public markets (external hedge funds or internal absolute return strategies). Stakeholders need to wake up and conduct proper oversight of these funds without micro-managing them.
Please go back to read Kip McDaniel's article on Canadian pension funds in the winter issue of ai5000, paying close attention to Leo de Bever's comments. He gets it but where I disagree with him is that pension fund managers are not paid anywhere near what hedge fund managers are being paid in performance bonuses. Unlike hedge fund managers, pension fund managers do not have skin in the game or high water marks, so they shouldn't be paid like hedge fund or private equity fund managers. Also, they are pension funds, not hedge funds or private equity funds, which is something managers and board of directors tend to forget.
Mr. Y: Let's shift gears and go back to the stock market. In last year's outlook 2009, you totally missed the boat on financials. Why is that and what do you see for financials going forward?
Editor: I will admit that I made money on my other calls but steered clear of financial stocks. What did I miss? For one, the big banks had a license to print money because they were borrowing for free and trading away in all sorts of risk assets.
The one thing banks didn't do is lend money, especially to small businesses. The 2008 crisis was essentially a liquidity crisis and banks are still reluctant to lend past three year terms. They prefer trading in capital markets, making a killing in the process.
A lot of the TARP funds that were paid back recently were paid back because bankers do not want governments to interfere with compensation practices, which are grossly out of whack. Soros was dead right about alignment of interests. The wimps at investment banks want to make the same bonuses as hedge fund managers but they got no skin in the game, and often take reckless risks to deliver the big performance figures.
Going forward, I think it will be a lot tougher for the financial sector as the Fed might surprise with a shift:
Absent balance-sheet expansion, the profit outlook for banks and financials is iffy, which is reflected in the sector's recent underperformance in the stock market. Moreover, the likelihood of the bond market beginning to price in an eventual Fed tightening will lead to a flattening of the yield curve, according to BCA Research's Daily Insights.
Financials have enjoyed a "free lunch" in a record steep yield curve, the research service continues. With the short end of debt market anchored at near zero by the Fed's fed-funds target, yields escalate sharply with progressively longer maturities.
That provides a built-in wide profit margin for banks that borrow short for practically nothing and reap yields of 2% or 3% from intermediate-term Treasury notes. Leverage that many times over and banks reap lush profit margins -- so long as their short-term borrowing costs remain low.
Were the yield curve to flatten substantially, banks would have to depend on a revival of residential real estate to power their earnings growth, BCA contends.
"Here, the outlook remains very shaky. House prices face a difficult 2010, with a new wave of foreclosures expected as mortgage resets accelerate and government mortgage and foreclosure programs eventually end.
"From a longer-term perspective, there are even more troubling signs for banks," BCA continues. Banks had been able to expand their assets faster than the economy from the mid-1990s until last year. That's no longer the case and banks' balance sheets are likely to lag the economy's growth, it adds.
"Bottom line: The financial sector in general, and banks in particular, have entered a period where lagging profitability is likely to trigger underperformance, especially if perceptions of future monetary policy slowly begin to shift and the deleveraging cycle plays out similarly to past periods (i.e. the early 1990s)," when banks' real-estate loan losses also crimped lending, BCA concludes.
If the Fed signals, however obliquely, that it is moving away from its near-zero-rate policy, banks and financials will lead the stock market lower, perhaps severely so.
I think BCA is right, a shift in monetary policy will deal a blow to banks as their capital markets operations, where most of the profits are coming from, will not be as profitable. However, one senior bank economist told me that higher rates also mean fatter margins for banks on existing lines of credit that expanded during the last year. This will cushion the blow.
Mr. Y: So are you neutral on banks? What about the rest of the stock market?
Editor: I am neutral on big US banks, less so on big European banks where I see more balance sheet problems weighing them down.
For the broader stock market, you have to pick your spots well, and stock selection will be the key going forward. Forget the big beta moves that you saw in 2009, 2010 will be all about picking your sweet spots. There won't be any free lunches in the next 12 months.
Keep in mind that some very respected strategists and analysts think the stock market could be jolted in 2010 if economy stumbles:
Ned Davis analyst Lance Stonecypher said it's too early to make a shift, but as stocks continue to rise next year, they will become pricey, and a move to more defensive stocks like consumer staples, telecommunications, utility stocks and health care -- sectors that sell things people need regardless of economic strength -- will be warranted. Kostin agrees and notes that investors will also prefer dividend-paying stocks in the second half.
I happen to believe the liquidity-driven rally has legs to run and that investors should continue to buy the dips.
Mr. Y: Please discuss this further and relate it back to your thoughts on the liquidity driven rally...
Editor: Sure thing. In response to the credit crisis, we had unprecedented monetary and fiscal stimulus. We also had massive quantitative easing in the US and around the world, which added to the liquidity tsunami.
I tend to think of liquidity in broad terms. Money is flowing from investment banks, pension funds, insurance funds, endowment funds, sovereign wealth funds, hedge funds and private equity funds. All that liquidity has to flow somewhere and in 2009, it flowed primarily in risk assets.
In 2009 you had a massive liquidity-driven rally. In 2010, there will more of a fundamentally-driven rally, but there will be plenty of speculative activity, especially in new sectors like renewable energy. Don't be surprised if we see a new bubble shaping up in this sector.
Mr. Y: Stop right there. You've been pumping solar stocks for some time now, especially Chinese solar stocks. I can accuse you of talking up your book, just like you accuse Bill Gross and others of talking up their book. Any comments on this?
Editor: Yes, let me comment. First, unlike Bill Gross, I do not manage billions. Second, I have repeatedly warned readers that solar stocks are volatile and if you can't stomach gut-wrenching volatility, don't even think of buying them. Hedgies love to manipulate these stocks, bringing them down so they can scoop up some more at attractive levels.
Third, and most importantly, I will invite readers to go back and read my post on why small beautiful. I like to pay attention to what the top hedge funds are buying and selling, not what analysts are touting. Hedge fund managers have skin in the game, so I know when they are buying or selling, they do so with conviction, at least most of the time. The data is lagged, but it gives me enough insight as to what sectors I should be focusing on (see update on hot hedge fund trades for 2010).
Mr. Y: And what other sectors do you like for the new year?
Editor: Lots of other sectors, including semiconductors, software, networking equipment, storage (tech in general will continue to do well so I am bullish on QQQQs), nat gas, medical device companies, etc. I am not going to get into specific names right away, but will update this post with some as I do more research (Note: see my subsequent comment on hot hedge fund trades for 2010).
Mr. Y: Ok, let's have some concluding thoughts. Why did you ask "Black Swans or Black Sloths?" in your title?
Editor: Because I feel that those folks who are focused solely on Black Swan events are missing the bigger picture, namely, the slow motion Black Sloth events taking place across the world.
Importantly, the global pension crisis will not disappear overnight. It is a long-term structural issue that will plague governments for years. In fact, part of me thinks that the Fed and other central bankers will try to engineer inflation to partly offset future pension liabilities.
Mr. Y: And will they succeed in these attempts?
Editor: My worst fear is that they will fail miserably, creating another generation of paupers. I hope I am wrong, but this remains my worst fear for the next few years. I do hope monetary authorities and governments take the pension crisis more seriously.
Mr. Y: Thank you and Happy New Year.
Editor: Happy and Healthy New Year to you and to all my readers.