ITAÚ: Where to Next?

If one had departed the market scene at year-end and returned at March month end one could be forgiven for thinking that not much had transpired. A point-to-point look would suggest flat global equities, slight USD weakness and rallies in sovereign credit and broad commodities ( chk). Having not departed the scene, we know all to well that such a comparison fails to recognize the violent sell off across assets in the first 6 weeks of the year followed by an equally violent cross asset rally over the last six weeks. Where do we go from here is the question of the day; an answer will require a look at where we have been and some thoughts on various paths forward.

WHERE HAVE WE BEEN? 

A couple of thoughts stand out. First, financial markets have come a long way in the past six weeks with double digit rallies in equities and commodities coupled with sharp moves in FX and bonds. Many assets seem extended on a near term basis at least and one wonders how much gas is left in the tank. Confusion is arguably greater today than at any point year to date.  Secondly and perhaps more importantly as a guide to the future, the weak dollar argument made in these pages some months back (see What’s the Bull Case date/link) has clearly worked its magic even if said dollar weakness has been quite muted.

As a quick reminder the weak dollar arguments suggests that it is the one factor that can push back if not reverse the three negative feedback loops of Fed rate hikes, China SOE reform and commodity dysfunction (See 2016 Outlook: And the Chickens Come Home to Roost date/link). A weak dollar addresses all three concerns: it boosts US exports and manufacturers, supports China SOE reform by allowing the Yuan to weaken without devaluation and underpins oil prices and commodities in general. A weak dollar provides further support to credit EM and DM as well as inflation and hence may benefit corporate earnings also.

However, it is critical to note we have not yet seen a weak dollar – what we have seen is a range trading dollar that is roughly in the middle of its range. A two way dollar has been sufficient to get global stocks back to flat – the key question today is whether it is sufficient to propel risk assets, especially equities, to new highs.

The third point to make is that while financial asset prices have rolled down the hill and then back up, the global economy has been heading in one, downward, direction. Europe is back in deflation and struggling with consumer and business confidence, immigration and Brexit issues. Japan is close to recession while China continues to slow. The US economy has limped into 2016 while the broad emerging economies continue to struggle with political and economic policy questions across the globe. The global growth slowdown is real and the policy response to date has been limited to monetary policy. This is insufficient.

WHAT ARE THE POLICY OPTIONS? 

Europe and Japan have entered negative interest rate policy land (NIRP) with mixed reviews. The only thing that seems clear is that neither the BOJ nor the ECB wants to go much deeper into negative territory. The near term effect on banks in particular and on currency exchange rates in general is not what the doctor would have ordered; the effect on credit markets at least appears more positive with recent European issuance approaching record levels.

In addition to NIRP, Japan would also seem to have room for fiscal stimulus via either a supplementary budget or a delay of the scheduled 2017 consumption tax increase. Rumors suggesting one or the other are flying ahead of Japan’s hosting the G7 meeting in late May. An overt policy of fiscal stimulus by a major economy would be very positive sign that some governments (including Canada’s new Govt it would appear) are recognizing that monetary policy in and of itself is insufficient to address the demand shortfall. Japan may also have the option of spending the money saved by issuing government debt at negative rates (10 year JGB now yields -0.09%) which given Japan’s debt load is bound to be considerable.

China’s bout of financial asset volatility seems to have stabilized for the near term at least. However, a recent issue of China’s Beige Book, a private sector report gathered along the lines of the Fed Beige Book process, did have an interesting comment on corporate behavior: first companies stopped borrowing, then they stopped investing and now they have stopped hiring, a comment supported by China’s worst new job data in four years. If true this is not good socially, politically or economically and would suggest further weakness in demand and more supply looking for a home. Understanding the pace and intensity of China’s reform process remains a key macro focus.

All this brings us to the Fed and its recent discomforting habit of appearing to speak in tongues. First was the December rate hike and the suggestion of four additional hikes in 2016, which gave way to very dovish comments in its most recent meeting including a reduction in the 2016 hikes from four to two which helped fuel the financial asset rally. This in turn led to some efforts at walking back that dovishness over the past few weeks before Chairwoman Yellen’s March 29th speech in NYC where she reinforced that dovishness.

Markets have responded with Fed Funds futures now suggesting only a 19 basis point hike in the rate before year-end. This implies a complete reversal of risk and reward as any hint of a more aggressive Fed going forward would lead to a risk off scenario. The Fed would seem to have limited room to maneuver: an April rate hike seems highly unlikely leaving May and June before the summer and then the September meeting before the US Presidential elections. Financial market conditions in the US remain tight with an IPO market that is the weakest since 2009 and very limited appetite for anything but high-grade corporate debt.

THREE POSSIBLE PATHS FORWARD

The Fed would seem to have three possible options or paths forward. The first would be to raise rates in either June or September. June is right around the Brexit vote and so somewhat problematic. The second course of action would be to stay on hold and not raise rates at all this year while the third would be to work actively with other monetary authorities to actively weaken the dollar… the 21st Century Plaza accord noted in earlier writings (See Why the World Needs a Weak Dollar, date/link). The potential for a transitory pick up in inflation over the next few quarters will make this a tricky period.

Given current market pricing, if the Fed chooses the first course and decides to raise rates the risk is that financial assets, especially equities, sell off perhaps leading to a US economic recession as consumer confidence cracks. A rate hike would also reverse dollar weakness and thus take away the weak dollar support provided to commodities, emerging market financial assets, China reform etc.

Limited dollar weakness, especially versus the majors, would be the likely outcome of path # 2, a Fed that stays on hold throughout the year. The Fed’s recognition that the neutral real rate of interest is lower than it had thought together with its concerns that the global economy remains fragile and could pose risks to the US economy suggests a much more balanced Fed than appeared just a few months ago. 

In this scenario, the large current account surpluses in Europe and Japan would tend to support those currencies, especially if financial players are sidelined. Risk assets would also be somewhat stabilized at least from Fed action.

Of course should the Fed and others meaningfully coordinate (unlike the rumored Shanghai Accord) to drive the dollar to say 100 vs. the yen and 1.20 versus the euro then risk assets would likely have a significant rally taking the S&P for example to new highs. Unfortunately, the recent stabilization in financial asset prices make such coordination less likely (the so called Yellen put).

The idea that there was some informal coordination in Shanghai is hard to prove or disprove but it seems more like creating a story to explain market action than a likely course of events. Even if true however it would seem to imply an ability for Central Banks to support asset prices rather than the real economy. Since this is in line with the evidence of the past several years it suggests that much more is needed to reverse the slowdown in global demand, growth and inflation let alone than as a rationale to get long.

INVESTMENT IMPLICATIONS

The question of whether one should get long (er) is relevant given that many active managers are underperforming. If the Fed is on hold and the dollar is unlikely to strengthen materially then the big downside risk so apparent in a four-rate hike world would seem off the table. At the same time most financial assets have rallied sharply since mid February lows and appear overbought at a minimum, suggesting limited upside. 

Valuation is not overly supportive, technicals continue to point to new S&P lows and risk positions such as long oil have built up very sharply. Earnings are on the docket and in the US the consensus forecast calls for a decline of 7% year on year; the hope is that Q1 may mark the bottom of the earnings down cycle but it may be too early. With no top line growth and a growing focus on zero based budgeting it’s hard to get excited about inflation or demand. A Fed on hold would seem to support the “rolling top” thesis for US equities.

It would be just like the markets to suck everyone in on the promise of no more hikes and then lower the boom – hurting the most people as Mr. Market is wont to do.

This is especially the case given that the underlying world economy has yet to show signs of stabilization let alone a growth pick up. For that more overt policymaking will be required. Fiscal policy as noted above would be a great place for Europe and the US to take the growth baton. As noted however neither seems likely in the near term with Germany recommitting to a balanced budget and the US fiscal stance frozen until mid 2017 and a new President’s policy program.

While it may not be exciting as the past quarter where we may be headed is to a place that is neither boom nor bust with the Fed having taken out the tails with its more nuanced stance. Risk reward suggests a cautious stance remains appropriate. As such non-USD credit plays remain appealing, as does gold for insurance purposes. Long duration UST remain appealing on pullbacks while those wishing to put more money to work in equities should look Eastward to Japan down 10% year to date with rapidly improving corporate governance, attractive valuations and new fiscal year forecasts that should show companies able to make money down to 100 yen to the dollar. Money has poured into EM assets over the past month with folks desperate to call the bottom; the call here remains long USD EM Sovereign debt, which should continue its strong performance.