The following assessment has guided our investment activities since mid to late May. Given the strong rally of risky assets earlier this week, "ultra-bullish" is now a bit too strong. However, we still think that risky asset markets have additional upside, and perceived safe havens like U.S. Treasuries could see another five to ten percent downside at the long end of the curve. We're still in a volatile, sideways environment though, so investors will need to be attentive to future opportunities for portfolio rebalancing and pulling in bets on risky assets.
It's a bit strange to suddenly find ourselves in a position of ultra-bullishness, but strategically, we think investors should consider reducing exposure to safe-haven assets like U.S. Treasuries in favor of riskier assets, or at the very least, use recent market dislocations as an opportunity to rebalance a well-designed strategic allocation.
Market volatility and political uncertainty are likely to remain elevated, so adding risk to a portfolio will almost certainly involve taking some lumps (and may therefore not be appropriate for every investor). But risk is widely on sale at the moment, while perceived safety is extremely pricey, at least for now. We also think investors with a global focus may want to consider tilting risk exposures away from the U.S. in favor of overseas markets until there is more clarity over the 2013 balance of power and direction of policy in Washington, DC. The observations and opinions upon which our view is based are outlined below.
- At current levels, markets appear to be pricing in a prolonged recession. But financial indicators continue to signal a short recession in the first or middle half of 2012 and a quick (though tepid) recovery.
- Germans have been the primary beneficiaries of the euro currency area (EMU). Despite their stubborn insistence on austerity, reality may slowly be dawning on them (if not, it eventually will).
- If Spain experiences fiscal failure, the euro experiment is over for all intents and purposes, and Germany's export markets will contract considerably.
- The most recent can-kicking measures reflected the importance placed on preserving Spain and Italy's EMU membership. Spain simply cannot be allowed to fail.
- Recent measures such as the ECB's long-term refinancing operations (LTRO) have run out of steam much faster than prevailing macro paradigms expected. This should not have been a surprise.
- If a recent Bank for International Settlements workshop is any indication, the mainstream macroeconomics profession is in as anxious and uncertain a position as it was in 1932.
- Recent multi-national summits have produced little in the way of public announcements, but there appears to be a flurry of activity behind the scenes, especially in Europe.
- Although none of its actions over the past several years have solved the currency area's primary defects, the European Union has eventually blinked every time markets forced its hand.
- Don't underestimate the political power and influence of Europe's banks or the fragility and stress they are experiencing. Europe's banking system will not be allowed to implode.
- The ECB announced it would stay pat on its interest rate target. This looks preposterous from most macro points of view, but may not be, as it (1) reflects operational reality, wherein the EMU framework prohibits the ECB from adding to net financial assets (thereby assuring that its financial system repeatedly ends up in a state of Ponzi-like fragility), and (2) intensifies the growing pressure on the EU (and by extension, the G-20?) to come up with a durable fiscal framework for the EMU (if not the entire EU).
- The rumor mill seems likely to churn out plenty of hope in coming weeks, which could make for a nice June rally. The Wall Street adage is to "Sell in May," but we've been buying.
- What agreements arise from the EU and possibly G20 by late June, if any, will determine how long a rally can continue.
- European markets are worth consideration given (1) how hard they've sold off, (2) potential for positive policy surprises, and (3) the likelihood of rising political and fiscal uncertainty in the U.S.
- Among individual issues, there are some table-pounding, high-quality franchises in Europe selling at very cheap prices.
- The U.K. government may be floating ideas meant to undo some of its ill-advised austerity programs-and "growth bonds" sure beat war bonds, which is how the world last emerged from a synchronized balance sheet recession.
- Certain European countries that are outside the EMU (and thus remain monetarily sovereign) are interesting from a macro standpoint.
- Germany's confidence in morality-based economics may be shaken, but there will be limits on how much upside is actually permitted in Europe (which is far more conservative than conservatives in the U.S. believe).
- As the experience of Japan shows, neoliberal tendencies can screw up otherwise good policy ideas in short order-negative surprises are still very probable at some point.
- For the first time in my 12-year career, U.S. Treasury prices appear to be overdone. We believe long bonds could experience a 10-20% correction in 2012 or early 2013.
- Beyond such a correction, we don't see huge downside for (truly, i.e., monetarily) sovereign bonds, which (beyond some short-term maturities) will provide a positive overall yield to maturity.
- The U.S. Congress is an unwelcome wildcard as long as certain members are willing to play political chicken with the U.S. debt-ceiling limit.
- Given the right mix of policy errors, yields in developed markets could still see Japan-like levels in the years ahead (prices and yields move inversely).
- Chinese stocks have been pricing in a slow growth regime for two years now.
- A great deal has been made of falling power consumption, manufacturing indices, demographics, and public statements about lack of planned easing measures.
- However, policymakers have been moving in the direction of easing on both the fiscal and monetary fronts.
- The government's focus on domestic consumption appears to be gaining some traction, which might help to explain lower power consumption and crummy manufacturing PMIs.
- While they are a minefield of agency risks and other complexities (which in capital markets is always a matter of degree), there appear to be some deep values among Chinese equities.
- Japanese equity markets are cheap. Cheap, cheap, cheap.
- The Japanese government continues to commit the kinds of policy errors that have put its economy and financial markets where they are.
- Internal demographic trends (as opposed to overall population growth rate) should be growth supportive in coming years (though perhaps not immediately).
- Once Japan's economy and equity markets gain traction, Japanese Government Bond yields could rise. This will NOT be a harbinger of Japan's imminent fiscal collapse. The hedgies and others betting on such an outcome have no idea how a modern monetary economy operates.
- Most key EMs have room for policy easing and are beginning to use it.
- U.S. fiscal tightening and a strengthening dollar could have negative macro impacts in many countries, as they did in the late 1990s.
- Those pressures may be offset to some extent by weakening of domestic currencies and economic evolution (e.g., toward domestic services over lower value activities).
On the U.S.:
- This is where the outlook gets interesting. Much of the world is now offering upside surprise potential, which the U.S. has already been doling out for a couple of years.
- The U.S. economy and financial markets have outperformed most of the world, thanks to our divided government's inability to similarly punish its domestic economy.
- A sweep by either party in November elections could unleash a whole bunch of stupidity (worst case) or legitimate pro-growth policy (best case, but low probability).
- A continued split between the Executive and two Legislative branches seems more likely, but either outcome risks no action on the so-called fiscal cliff of 2013, when a raft of deficit-inducing measures (deficits are a good thing in a prolonged balance sheet recession) are set to expire, and significant deficit-reduction measures (thanks to the Tea Party and other GOP's debt-ceiling brinksmanship in 2011) will take hold (a bad thing).
- It does not look like the Fed is contemplating concerted action or a new round of 'unconventional' policy measures.
- It's reassuring that the federal budget has turned back into deficit after recording the largest surplus in four years in April (h/t Mike Norman), but the overall trajectory is still down, which eventually leads to a financial breakdown of some kind and/or recession.
- If efforts to address the fiscal cliff fall apart, which is not outside the realm of possibility, we would expect some significant carnage in U.S. markets, similar in magnitude to Europe's recurring meltdowns of recent years.
- That said, we expect the U.S. economy to continue growing in 2012, albeit at its subpar pace. Our internal models are putting a near-zero probability on recession this calendar year.
- Earnings estimates for U.S. stocks should surprise modestly to the upside in coming quarters. As long as earnings multiples don't contract, that should support U.S. stock markets.
- Overall, U.S. stock markets should continue to perform reasonably well for another year or two, as long as there is a reasonable probability that the fiscal cliff will be addressed constructively.
Finally, a parting thought-we subscribe to the notion that prevailing approaches to macroeconomic theory, modeling, and policy design and implementation are broken. The profession must work to close the gap in order to avoid intellectual bankruptcy, but this will take courage and, unfortunately, the passing on of influential but wrongheaded figures (Alan Greenspan's recent comments on the bond market come to mind).
Sadly, professional courage is rare, and passing on, while inevitable, can take a long time before sufficient room is made for new ways of thinking. However, looking at Japan as the ultimate example of modern macro policy and financial practices gone awry, there are at least three distinguishing features between its experience and that of the entire developed world now struggling with output gaps, de-leveraging, and slow growth or recession. Since the peak of its bubble around 1989, Japan's population has hovered around two percent of the world's population, and its political system rarely fostered radical change (until very recently, and on the policy front, it's still been a disappointment). Today, more than 10% of the developed world is struggling with slow growth and excessive unemployment and underemployment, and many of those people live in countries with fairly reactive political institutions. The world's capacity for the free exchange of ideas has also expanded exponentially since 1989. In short, as the shortcomings of the economics profession continue to be exposed by the ongoing struggles of millions if not billions of people in the current malaise, the coming years may prove fertile for advancing the understanding and application of macroeconomics-perhaps spurred on by electorates, like those in France and Greece, that insist there has to be a better way than the status quo. This might just be wishful thinking. Time will tell.
In the meantime, we are advising our clients to add some risk and lower their exposure to safe havens where appropriate, with the understanding that although these moves might eventually pay off, their portfolios could take some lumps in the meantime. At some point, we believe hindsight will confirm that today's markets present opportunities to savvy, patient, long-term investors.
IMPORTANT DISCLOSURES: Symmetry Capital Management, LLC (SCM) is a Pennsylvania registered investment advisor that offers discretionary investment management to individuals and institutions. SCM is not affiliated with or related to Symmetry Partners, LLC. This publication is for informational, educational, and entertainment purposes only. It is not an offer to sell or a solicitation to buy securities, or to engage in any investment strategy. Past performance is not indicative of future results. This material does not take into account your personal investment objectives, your personal financial situation and needs, or your personal tolerance for risk. Thus, any investment strategies or securities discussed may not be suitable for you. You should be aware of the real risk of loss that accompanies any investment strategy or security. It is strongly recommended that you consider seeking advice from your own investment advisor(s) when considering any particular strategy or investment. We do not guarantee any specific outcome or profit from any strategy or security discussed herein. The opinions expressed are based on information believed to be reliable, but SCM does not warrant its completeness or accuracy, and you should not rely on it as such. All views and positions are subject to change without notice.