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By dispelling the illusion of a potential normalization of U.S. key rates, the publication of the FOMC minutes served as the rain on the global capital markets’ parade. The market’s bluff, which consisted of fearing the Fed would take a hawkish turn while hoping it would do just that (thus lending weight to the theory of a U.S. economy strong enough to forego the Fed’s easy money policy), has been unmasked. The Fed will not change the direction of its monetary policy in the foreseeable future and, as we expected, this scenario raises a number of questions:
- On the fundamental economic situation,
- On the credibility of the consensus that long-term interest rates would rise and the dollar would see a healthy appreciation.
- On the foundation of hopes developed on the markets and therefore their valuations.
That the market reaction has been negative to this point is entirely understandable.
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The onslaught of bad news won out last week as global stock exchanges endured a heavy correction and investors retreated in a massive flight-to-quality. At a time when some observers already see a buy opportunity in the recent slide, we continue – given our view of the macro-economic and geopolitical situation – to take a protective stance in the near term. There are four main reasons behind this:
1- None of today’s geo-political conflicts (Iraq, Gaza Strip, in Ukraine-Russia or South China Sea) seem to be ending anytime soon. The multitude of conflict zones and the extreme complexity of the present situation could well indeed fuel investor risk aversion.
2- The European economic picture has taken a bad turn. The lack of domestic growth drivers, amid an environment of soft global trade, has trumped the economic recovery. Current forecasts are no longer tenable and news in the coming months is sure to lead the market to revise its forecasts on future growth markedly downward.
3- The ECB is behind the ball when it comes to fighting deflation. Its intervention, if it ever sees the light of day, will not have the same impact on the markets as Fed action, particularly for the banking sector where all signs point to a sustained downturn.
4- Anticipations of a Fed rate hike have diminished due to recent international developments, which helped in limiting the damage on the US equity indices. However, the postponement of Fed normalization cannot be perpetually seen as good news.
Given the wealth of evidence, the correction that started several days ago is likely to continue. Our recommendations remain:
- Steering well clear of the equity markets, including in the emerging markets.
- Beefing up exposure to sovereign bond markets (the configuration of the T-bond market strengthens our scenario of a drop towards 2.25% for the 10Y), including for peripherals in southern Europe.
- Increasing exposure to precious metals.
- Easing exposure to the euro vs. the dollar over time.
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Our contrarian outlook for a global growth slowdown starting in the second half calls for caution in terms of asset allocation
Global growth slowing next year to 2.8% versus 3.2% this year
- U.S. growth is failing to take off: real estate prices have increased too fast, thus squelching the recovering in the construction industry, growth inertia in services continues to hurt the job market, weak productivity growth has failed to provide the necessary boost to investment that would extend the cycle. Growth disappoints and will not exceed 2% this year or next year.
- Deflation is settling into the euro area and is propagating to the countries in the northern part of the currency union. Following the favorable boost from the economic recovery, keeping the momentum going proves difficult due to the deteriorating export outlook. Germany is not playing its role as an economic engine, other countries are not recovering. Next year, growth will fall to 0.9%, after 1% this year.
- The situation for emerging markets suffers from the negative influence of the Chinese economy: export markets are drying up, soft demand for commodities and devaluation of the Renminbi. Imbalances and chronic shakiness increase the temporary instability. The Russian economy is tipping into a recession, Brazilian growth falls after the uptick from the World Cup, the effects of Indian reforms are diluted by a difficult economic situation.
New bond rally
- The Fed will not see « tapering » through to the end; key rates will stay at zero. The 10Y will decrease to 2-2.25% before the start of 2015.
- The ECB will embark on a long journey of non-conventional monetary policy. Long rates will fall, following the bund, whose 10Y yield will fall to 1-1.25% before early 2015. Interest rate gaps between countries in southern Europe and the German bund will stabilize before widening again in 2015.
- The risk of deflation increases the world over, commodity prices fall back as instability increases. Brent drops to under $90/b.
Growing instability on the forex markets
- The Fed’s strategy shift contradicts the ECB easing, the euro does not fall.
- The BoJ roars back to life after the failure of Abenomics, the yen tumbles in 2015.
- Forex risk increases in EMs, particularly in Asia where the currency war pits the Japanese against the Chinese.
Downturn in the equity markets
The change in outlook weighs on earnings forecasts and cyclical stocks.
The S&P recedes to 1,600, the EuroStoxx returns to 300 points. Industrial equities take a hit, with the DAX squarely in the crosshairs.
Over the past few years, we have been resolutely bearish on the dollar, in contrast to the consensus view. The reasons behind our contrarian outlook are three-fold:
- We foresee lastingly low GDP growth now that the 2008 crisis has brought an end to the support previously provided by private sector debt—creating a shortfall we estimate at 1.8 percent a year, and pushing U.S. potential output down from its pre-crisis 3.0–3.2 percent range to somewhere between 1.5 and 2 percent today.
- We expect the Federal Reserve to stick to its unconventional monetary policy for now and the greenback to continue losing ground as a result. To make matters worse, the euro area has opted for a structurally deflationary policy mix to sustain the euro, even if that means undermining European industry.
- We anticipate an eventual inflationary exit from the 2008 financial crisis—one that will almost certainly affect the United States much sooner than the euro area.
These factors also prompted us to cut our projections for the dollar in June, when we simultaneously lowered our 2014 forecast for the U.S. economy—and thus for long-term Treasury yields as well. Although challenged by developments since the early summer, our bearish dollar outlook seems once again pertinent in the wake of this week’s FOMC meeting.
So just how low might the dollar fall?
Japan’s reflation campaign looks impressive. Unfortunately, it is unlikely to work.
True, the substantial depreciation of the yen brought about by the BoJ policy of massively injecting liquidity into the system has driven up corporate profits since the start of the year—even way up in some cases. But this competitive surge has had such a depressive effect on other economies in the region that they now offer a shrinking market for Japanese goods. In fact, what Japan is exporting may well be its own deflation, and to a degree at least commensurate with the inflation target set by the government.
So what can be expected of “Abenomics” if it fails to engineer a rebound in exports? Domestic forces certainly won’t generate inflation: population aging has already done serious damage to the country’s growth potential, and encouraging mass immigration—the only policy with a chance of reversing that trend—is simply not on the government agenda today.The other measures announced will therefore be about as effective in boosting potential output as a band-aid on a wooden leg. With its supply-side bias, the Abe administration’s strategy will have no lasting impact on growth unless it succeeds in re-igniting demand.
All this makes it hard to buy into the current stock market enthusiasm. The Nikkei bull run since last December just doesn’t square with the persistently bleak outlook for the Japanese economy. What follows is a new analysis of this issue by Frank Benzimra, one that concludes with the firm recommendation to dump Japanese equities.
“Tenkan, a term in several martial arts for a swift, 180-degree pivoting move, has provided the economist and Asia specialist Jacques Gravereau with an analogy for illustrating the ability of the Japanese people to carry out radical changes in direction collectively, flexibly, and energetically.”
Does the policy shift initiated a few months ago by the Japanese authorities qualify as tenkan? On this one, the jury is still out, but in any event, this experiment already represents a key stage in the crisis affecting the developed countries.
To highlight its importance, we are publishing two papers on this question. The first one, a brief attempt to put Japan’s deflationary episode into perspective, seeks to shed light on why the country was previously in so little of a hurry to deal with this affliction, and why it now feels compelled to take an entirely new tack. Download 1st article.
The second paper is by Frank Benzimra, a specialist on the Japanese economy and financial markets based in Asia for about ten years, who has been kind enough to share his thoughts with us. He begins by explaining how Japan managed to make it through fifteen years of extremely high public debt without lapsing into chaos. He then goes on to discuss the pioneering aspects of Prime Minister Abe’s new policy. In conclusion, he puts forward three possible scenarios for the outcome of “Abenomics,” along with the three investment strategies they imply. Departing from our usual practice, we are publishing this contribution in English. Download Frank Benzimra’s article.