Q4 Outlook: Markets Heating Up

by: Daniel Zurbrügg
4th Quarter Report – October 2010
It’s been a bit more than three months since we published our last edition of “Echo from the Alps” and markets have moved significantly since then. The rebound in equity prices that we anticipated, based on the reasons outlined in our last edition, has indeed been taking place and most major equity markets are up between 5% and 10%. A lot of investors were taken by surprise since they had not anticipated such a strong performance given the rather negative sentiment we faced back in July. We felt that valuations looked quite attractive in summer, but, it took some improvement in overall market sentiment to drive prices up. In general, there seems to be some relief over the risk of European sovereign debt and it is therefore not surprising to see the attention shifting back to the U.S. and the debt problems there.
This shift of focus back on the U.S. can also be seen in foreign currency markets. The U.S. Dollar has lost significant ground in the third quarter falling more than 10% versus other major currencies including the EUR, which was most surprising in our view. It is obvious that recent comments from the Fed and the FOMC indicate that they do not have any real desire for a strong currency and that the main focus is to bring the economy back on track and to finally create more jobs. The wording used in their communications shows that they are willing to risk future inflationary developments and prefer such a scenario over a deflationary environment. Also, the talk about QE2 (Quantitative Easing 2), by directly purchasing treasuries, leaves no doubt about their intentions and therefore it is not surprising to see the U.S. Dollar falling. We do not see any factors that would point towards a reversal of this trend any time soon.
The weakening U.S. Dollar is causing problems for countries like Japan, which relies heavily on exports to the U.S. The Bank of Japan has tried to counter the current Yen strength by intervening in the market and by cutting it’s official interest rate to 0%. In our view, what they can do to weaken their currency is very limited since intervention only works in the short-term and interest rates are at a bottom. Given the fact that Japan’s deficit is even worse than that of the U.S., it is surprising that the Yen has been appreciating as well versus the U.S. Dollar. We believe that the basic difference comes from the fact that Japan’s deficit is backed by large savings of private households in Japan, actually, their reluctance to spend has been one of the reasons causing such a long period of weak growth. We will look into the various factors driving currency prices later in this publication.
It doesn’t come as a surprise that in a climate of weak economic momentum coupled with disastrous government deficits, tensions among the most important economic blocks in the world are increasing. Many fear that the way out of this, for many governments, is to devalue their currency by printing more and more money. The current dispute between China and the U.S. is just one example. Washington points the finger at Bejing, but I think it is difficult to solely blame China for this, when at the same time the U.S. is also taking measures which will result in currency devaluation. Even worse is the fact that this is hurting China, which has huge amounts of currency reserves invested in U.S. treasuries; this is a dangerous game being played here. Also, the benefits from a weak currency are, in our view, overestimated. While it certainly helps export oriented industries, it does little to nothing to solve structural problems. Despite this, it is often perceived to be a “quick fix” economic solution, yet, while it might help exporters a bit, it diminishes the trust of foreign investors. In a time when countries such as the U.S. are so heavily dependent on foreign capital, it is not exactly smart to make your own capital markets less attractive. Additional (over-)regulation being implemented exacerbates the issue will cause a lot of foreign investment capital to flow to other places.
Speaking of additional regulation, the main topic in this area recently has been banking regulation, primarily the Basel III accord, which aims to make banks less vulnerable and requires them to keep significantly more capital. The lessons learned during the recent financial crisis made it clear that the failure of one major bank via “domino effect” cause a global banking crisis. We feel that the proposed guidelines in the Basel III accord are a step in the right direction and we will further look into this matter later in this publication.
We think that the outlook for global economic growth has remained moderately positive, but still believe that most of Europe and the U.S. will be lagging. We feel they will probably not fall back into a recession. We expect interest rates to remain at very low levels in these markets and, contrary to our view earlier this year, wouldn’t bet on rising long-term rates, or at least not yet. The rather aggressive measures by the Federal Reserve were even more than what we had expected and we think that while rising yields are off the agenda for a while, the risks for a further U.S. Dollar devaluation have increased.
While we are still relatively positive for global GDP growth, we think the biggest risks remain in the U.S. and Europe. The U.S. situation has the potential to worsen significantly and we actually feel that medium-term not only above average inflation is a risk but that even stagflation is a realistic threat. Lessons from the past, especially the 70’s, have shown that money printing will eventually result in above average inflation, possibly significantly above historical average rates. While monetary stimulus might help to improve economic growth short-term, structural problems, in today’s case the massive deleveraging of households and a basic fundamental loss of confidence in politicians, could eventually result in sluggish or even negative growth combined with high levels of inflation. Studying stagflation in the 1970s clearly shows that the supply shocks from energy markets do not explain the problem in its entirety. To make today’s situation even worse, we should not forget about today’s energy prices and the potential for further, possibly rapid price increases given the fact that most of today’s oil supply is controlled by economically and politically unstable countries such as Iran, Venezuela and others. Iran is holding presidency of OPEC in 2011 for the first time in over 30 years. There is a significant risk premium built into these prices and for a good reason.
Disclosure: No positions