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The Monthly Banker: 10 January 2011
The Monthly Banker: 10 January 2011
Financial crises occur in unexpected ways. So do economic recoveries. A year ago, few anticipated the wild swings of the financial markets; even fewer predicted what central banks would do. "It is tough to make predictions," as Yogi Berra laments, "especially about the future."
Will 2011 bring calm and bullishness? Unlikely. To see why this is so, I first recap the major events of last year.
1. Major events in 2010
Calm (Jan-Apr) – The talk of the Street in those early months was the ‘normalisation’ of policy rates. The green shoots of recovery, investors told, were sprouting everywhere. Stock markets were humming; banks no longer posed systemic risks. Reflecting this complacency is the VIX Index, more commonly known as the ’fear index’. In mid-April, it slumped to 15 - its lowest level since 2007 (see Figure 1). Fear no more.
Figure 1 VIX dips to lows before exploding
Triple Waterfall (May-Jun) – A series of negative events – Goldman’s probe, May 6 Flash Crash, Greece’s impending default – destroyed this Panglossian outlook. Market confidence melted in an instance. Moreover, the crashing Euro spooked many investors. As memories of 2008 October returned, deeply frightened investors fled equities into government bonds (not Greek bonds, mind you).
Quantitative Easing 2.0 (Jun-Sep) – Bernanke was forced to initiate a second round of QE to boost growth and reduce the overhanging unemployment. Ergo, the dollar tanked; governments bonds rallied significantly during the summer. Financial stability gradually returned.
European sovereign debt concerns again (Sep) – Ireland, Spain and Portugal saw their yield spreads relative to Germany widened to decades high. A second round of bailout emerged.
Inflation returned (Oct-Dec) – Food and energy prices rocketed as production were curtailed. In addition, speculative liquidity flooded into the market.
Speculative mood thrived (Sep-Dec) – Equities, commodities, and high-risk instruments all raced to the highs.
All in all, the past twelve months have been tumultuous, punctuated by periods of intense fear and optimism.
2. Economic Tensions will run high in 2011
It is our view that 2011 will be as volatile as the year past. Here is why.
First, the global recovery remains two-speed. This is a dangerous development because different rates of growth introduces friction on many aspects. For example:
1 - Trade. Deficit-laden US will continue to ’force’ China to revalue her currency, given her large surpluses. To that end, US may even enact some protectionist policies.
2 – Capital flow. Speculative capital generally flows to healthier economies, as captured by Figure 2. This trend will accelerate in 2011, perhaps overheating the recipient economies. Turkey, for instance, is considering lowering the policy rate to make its economy less attractive. Other may impose more stringent capital controls. FX intervention may become more frequent this year as export-led economies strive to hold onto their currency advantage.
3 - Diverging priorities. As the different rates of recovery differ, governments’ priority changed. Within Europe, for example, Germany had weathered the crisis better than many of her neighbours. This puts strains on the region as Germany favours a more deflationary bailout package than what some countries would like, or require (see November Monthly Banker).
Figure 2 Portfolio flows into emerging markets running hot
Second, inflationary concerns are deepening. As commodity prices increase, it is forcing several central banks to tighten their monetary policies. In Asia, this trend is already happening. India hiked its policy rate several times in 2010. China is starting to follow suit. ’Liquidity draining’ will be the focus for many emerging countries in 2011.
Third, advances in asset prices are becoming somewhat overextended. 4Q 2010 brought bumper profits for many speculators. Many assets, bar government bonds, went up. This promoted speculation into riskier areas, such as the small-cap stocks. As long as the QE2.0 is in placed, rampant speculation will flourish. But, as every reader knows, the market is a fickle beast. Her bullish mood can sour in minutes, melting confidence and prices. So another Flash Crash in 2011 is not to be ruled out.
Fourth, sovereign debt issues are still unsolved. Despite the bailout packages announced last year, concerns about the European sovereign debt linger. Time, was what the ECB and various European governments bought with these packages. But, will this time frame be enough to resuscitate a healthy recovery? We think not. Sovereign debts concerns may even spread to countries like Japan, or the US, both of which are tied with swelling government debts.
3. Still, stay overweight equities
Amidst this array of concerns and conflicting issues, financial markets will rock around. As such, another serious correction this year is almost a guarantee.
But while the global economy faces considerable headwinds, it is not my intention that investors should go out and short the market aggressively - because financial markets and economic developments are two distinct animals. Both have a life of their own. Sometimes, stock prices go up for no apparent reason, other than that they went up earlier.
Another point worth remembering is that QE is good for stocks. Liquidity supplied by the Fed fuels rank speculation in risky assets, like equities. The fact that mammoth IPOs, like General Motor’s US$18.1 billion sale, or AIA’s US$20.5 billion listing, were heavily oversubscribed shows a continuing healthy appetite across the globe. 2011 could even be better.
In fact, it is my view that stocks are actually a good way to hedge against the eroding purchasing power of currencies, as some firms can pass the rising costs to customers.
Overall, we are not too bearish on equities. Figure 3 shows the bullish forecasts on the S&P500 Index by major Wall Street institutions. All but one predicted higher prices ahead. The tsunami of liquidity flowing out of the States risks inflating a bubble in emerging markets.
4. Bond yields to go up in 2011
Another interesting aspect of these forecasts is that a majority of them expects higher bond yields in 12 months time. Just recently, the majority thought otherwise!
Regular readers of Monthly Bankers would understand my bearish stance on bonds. Technically, I concur with these higher yield forecasts. Below, I analyze various ten-year yield charts:
Figure 3 S&P500 Forecasts (As of 31 Dec 2010, SPX=1257; 10-year yield=3.365%)
Figure 4 (a)-(d) 10-year bond yields: down and up
US 10-year yield outlook – Swung wildly in 2011. After flirting with the 4% level in April, the yield lost ground for the next seven months, reaching a low of 2.4%. From that oversold level, a massive rebound took place, clawing back much of the lost grounds (see right).
What now? The next few months will be choppy, although with some upside bias. Like any other financial series, rates do not up in a straight line; there will be consolidation along the way. Specifically, the yield is expected to range in between 3.6% - 3%, before rising to test the 4% level again.
UK - The UK 10-year had a similar trend as the US. A sideways consolidation in between 3.6% and 3% is envisaged before the yield makes a push towards the 4% level.
Euro - This yield bottomed out earlier than many others, in late August. Thus it may lead the sector higher. However, the ongoing debt crisis in the Eurozone may cap the upside. The short-term range is plotted at 3.1% - 2.6%.
Japan - Had a huge rally since October, but that advance softened somewhat since mid-December. Still, a medium-term trend is bullish, with the target pencilled in at 1.4%.
Bottom line: 2010 marked a year of yield declines around the world. This year may be different. Inflationary pressure is rearing its ugly head in many places, proving fuel for another leg up in the long-term bond yields. Readers may watch to sell government bonds on rallies.
Another point worth mentioning is that many investors do not expect the Fed to increase rates for the next couple of years. The Fed itself had reaffirmed this expectation several times. Assured by this, leverage is again accumulating in the financial system. Investors ask themselves, "Why not leverage up as the cost of borrowing is dirt-cheap?"
Predictably, the carry trade - with the US Dollar acting as the funding currency – booms. A severe market dislocation is likely to occur when the Fed tightens in the distant future.
5. Secular Trends
In this year-end issue, it would be helpful to provide a discussion of some secular trends – trends that overshadow a large chunk of the day-to-day market fluctuations.
One, the commodity supercycle remains intact
Since commencing in 1999, this 12th year old secular trend is showing no sign of slowing down. In fact, it may even accelerate in 2011. Drivers of the bull cycle include:
1 – A shortage of energy resources. It is well-known that traditional energy production has difficulties in keeping up with the growing usage. This forces energy prices higher (see Figure 5)
2 – Significant time-lag in developing alternative energy sources. While there are many non-carbon energy sources, these channels are not fully utilized. Nuclear reactors, for example, are notoriously difficult to build due to the extended planning process.
3 – Growing demand for food, and, unpredictable weather. The past few months show the weather could be a driver for higher food prices in 2011. For example, wheat prices soared last July as a severe drought hit Russia. Australia’s food output may be curtailed as natural disaster strikes. Cotton prices may also increase as demand surges (see Figure 6).
Overall, the commodity supercycle is intact and poised to last for a few more years. What this means for ordinary people like us is that we face significant inflationary pressures – from petrol to food to cloths.
Figure 5 Firmer energy prices
Figure 6 More expensive cloths!
Two, emerging markets are the drivers of growth
Emerging markets survived the crisis relatively better than the developed regions because of they had less debt. Unlike the US or the British, many emerging market entities - governments, banks, and consumers – entered the turbulence with lower leverage. It is unsurprising that they recovered quicker. Some have even surpassed the pre-crisis levels. China, for instance, overtook Japan as the second biggest economy in the world in 2010. ICBC is the biggest bank in the world.
Below are some notable trends of this cycle:
1 – Consumption remains strong in emerging markets. Sales of consumer goods will expand significantly.
2 – Income growth is accelerating, especially in places like China. This speeds up the inflationary cycle.
In sum, many emerging countries are in once-in-a-lifetime industrialisations. The process, once started, usually continue for years.
Three, the interest rate cycle is at the mature stage
Since early eighties, interest rates have been declining across the world. This trend is now entering a mature phase. In many countries, interest rates are at rock bottom, especially in developed regions such as the US, UK, Japan, and Europe. There is simply no more room for rates to decline further (see Figure 7).
As the rate downtrends hit the lows, it marks the start of a new interest rate upswing. This secular trend is likely to last for some years, if not decades.
Of course, this trend will not progress in a linear way. For example, significant deflationary pressure still exists in the States because of her considerable output gap. This will delay monetary tightening. But other countries may not be so fortunate, especially in countries that are already expanding rapidly, such as emerging economies.
Accordingly, we favour staying out of long-dated fixed-income instruments.
Figure 7 Interest rates at generation lows
Four, the fiat ("paper currency") system is a step closer to destruction
The current international monetary system is under increasing strain. The US Fed is printing massive amount of money out of thin air, and this is crushing the value of the greenback. However, because the Fed is beholden to the negative domestic economic scene, such as the double-digit unemployment, loose monetary polity will stay for an extended period of time. Meanwhile,
1 – The epicentre of the debt supercycle is moving to the public sector. As risk taking recedes from the private sector, the government is quickly replacing these lost consumption. Further monetization of western government debt is a distinct scenario.
2 – The US Dollar is subjected to further weakness as the Fed print more (watch for QE3.0).
3 – Competitive devaluation across Asia ensures more money printing and a huge increase in FX reserves, both of which contribute to rising inflation.
4 – Gold will sit alongside paper money in the future monetary arrangement, whether central banks like it or not.
Overall, the fiat system is under huge strain at the moment. Unless governments take step to anchor their spending policy, risks of a sovereign default are certainly set to grow.