Equities: Is This as Good as It Gets?

After a stunning six-month rally in equities, commodities and corporate bonds, we are reaching a critical juncture for markets, which have swung from despondency to euphoria since March. Incoming data have moved the investment debate from whether a recovery is imminent to how strong and durable it will prove. I said back on March 10th that:

'Equities are now cheaper than for several decades on a cyclically adjusted earnings basis (and versus bonds) and stand at an extreme oversold level only seen a few times in the last century.'

The depression/deflation panic was clearly misplaced and I predicted a 40-50% trough to peak rally as deflation fears abated. Indeed 10 year inflation expectations in the TIPS market had jumped back to near 2% by June, driving the first leg of the risk asset rally. The six leading global economies this time around have applied 300% more fiscal stimulus and 500% more much monetary stimulus relative to GDP as occurred in the 1930's, and that was always going to be hugely reflationary.

Key factors that turned a hoped-for recovery in 1930 into the disaster of the Great Depression were a sharp hike in interest rates in October 1931 and a decline in the overall price level of 10% per year in 1931 and 1932. History isn't going to repeat and indeed the Bernanke Fed is loathe to risk tightening policy before any recovery is self-sustaining as reflected in capacity utilization climbing to at least 75-80% (ie not before end 2010 if markets don't force their hand). In fact, reflating asset markets was a crucial objective of public policy as much as avoiding CPI deflation, as balance sheets were so dangerously stretched in the US and Europe, and it has proved successful. Three factors have proved supportive of the ongoing risk asset rally in recent weeks.

Firstly, not only is the cycle bottoming earlier than seemed likely back in March, but the recovery is increasingly synchronized on a global scale (with Q3 marking the inflection point for the US and UK, and Europe already modestly rebounding as are the key Asian exporters). Secondly, central banks from the Fed to BOE, far from removing the punch bowl of monetary stimulus, are raiding the drinks cabinet for any leftover monetary hooch they can thrown into the mix to keep the party going. Thirdly, 10 year government bonds have sold off modestly so far, supported by a natural bid from commercial banks seeking to flatter their capital ratios, and central bank's own buying as well as still declining CPI inflation.

However, a number of risks loom large in coming months to unnerve complacent sentiment.

On the one hand, there is a risk that the early stages of recovery prove unexpectedly robust, and precious central bank credibility comes into question, leading to a flight from bonds and indeed the dollar. A full-blooded cyclical recovery may prove far riskier than the consensus anemic affair. Despite most equity indices at their highest since the Lehman debacle, 10 year bond yields remain very modest, and well off the highs seen in the June inflation scare. Would that calm survive a not inconceivable 5% quarterly GDP print for Q1 or Q2 2010?

Alternatively, if inventory restocking, particularly in Asia, has already run its course (and inventory to sales ratios are back to long-term averages, having undershot considerably), then it's possible that indicators like the Baltic Freight Index are signalling that a brief economic 'sugar high' is already subsiding and bullish survey data is misleading.

China, which has been a cornerstone of the bull case, has flattered to deceive in terms of reported growth figures and reckless lending fuelling commodity, real-estate and stock market speculation. Policy is now tightening by stealth and as that becomes increasingly apparent, and as China seeks to diversify its dollar exposure (possibly via surprise measures to partially open the capital account) it will inject volatility into markets.

Finally, the US and European (notably Germany, Switzerland and UK) banking sectors remain dangerously leveraged and undercapitalized, and vulnerable to a further round of write-downs from commercial real-estate and private equity loans as we see the refinancing schedule for boom-time loans surge in 2010/11.

A sustained zero interest rate policy prods investors along the risk curve, but also prods consumers to spend. On balance a weaker rather than stronger outcome seems more likely, but leading cyclical indicators suggest the strongest near-term rebound since 1983. Watch the next set of US savings data for a lead on which scenario will play out ie an upside or downside growth surprise in Q4.

Three secular trends will define the investment landscape for the next decade in the developed markets; they are the rising marginal cost of energy, demographic decline, and ongoing balance sheet deleveraging. All of these are negatives for sustained growth rates. However strong a reflex rebound, once the US stimulus expires, and budget deficits start to narrow, global demand will settle at a new lower level defined by real consumer income growth and productivity. Under those circumstances, the world economy cannot sustainably return to 2003-7 levels of growth, or anything close. That reality will define the investment outlook, and at this point it argues for a strategy of hedging downside portfolio risk rather than increasing upside exposure as we approach 1100 on the S&P.

Disclosure: None

Comments

[tobi:]

The fundamental problem is that the scenario of an unusually strong and early recovery will produce a signifant problem: Selling of T bonds and a tanking dollar, rising oil and other commodity prices in dollar terms although unemployment is still highly elevated and housing values have not found their absolute bottom. Their will be a gigantic deficit for years to come no matter how good the recovery is and a quick recovery, though it would increase tax revenue, would not be able to replace substantial borrowing which then would happen at significantly higher interest rates, which would then lead to higher mortgage rates and borrowing costs for everybody. So this is the real trap.

Aug 28 08:20 AM

[Larry House:]

I think your conclusions are spot on. We are heading for the "new normal," and we can't now know what that level will be and what stock prices are justified. It is certainly a time to err on the side of caution while the economic and demographic forces play out. I do not endorse sitting on cash. This would appear to be a time to be underweight stocks but to dollar-cost-average more into them over months to years with a keen eye on one's proper asset allocation determined by risk tolerance and investment horizon.

Aug 28 11:52 AM

[tc1:]

Very wise article, Sean, and wise comments by Tobi and Larry. Investors be careful and beware any "irrational exuberance" (e.g., 1929, 2000, 2007 and now in August 2009?) after having just rebounded strongly upward from the "irrational pessimism" (e.g., as overwhelmed most everyone in Oct-Nov 2008 and Feb-March 2009).

GE's ceo Jeff Immelt has rightly spoken of a major "reset" to the world economy, very much in line with what Sean et al. are saying.

Aug 29 01:48 PM