By Filip Mardjokic, CFA
By this time of year, we have seen more than a few forecasts and commentaries about what the market is likely to do over the next few years. I’d like to take something of a different approach: offer a view into where consensus is forming and discuss some of the risks these forecasts are predicated on.
Speaking broadly, most commentaries expect that a relatively benign growth picture coupled with continued global easing will drive wayward investors into riskier spread and equity products. The “Street” is so unanimously certain of this fact that as astute investors, we should be wary and look for ways to hedge against a contrarian outcome.
The consensus is that there is more juice left in these berries because of a few fairly compelling technical factors. In the fixed-income market, we will experience a genuine shortage of issuance. To start, most companies have already termed out their debt, and then batting cleanup, the Fed will buy up the last remaining bits of agency mortgages and Treasury bills. This will force spread investors to accept lower yield for more risk.
The Inherent Riskiness of “Riskless” Assets
At the time this post was written, the U.S. Treasury 10-year government bond traded at 1.78% and CPI was trending at 1.8%. This means that on a real basis, you earn nothing.
Aside from eroding your real purchasing power, this low interest rate environment has produced all sorts of weird market anomalies. Perhaps the cutest kitten in the litter is the inversion of the risk spectrum. If you calculate the breakeven rate on the universe of fixed-income products, you will notice that government bonds rank among some of the worst investment options you have, but the assets that were most associated with headline risk in 2009 offer attractive real yield and formidable downside protection.
To illustrate my point, let’s look at the cushion a 30-year U.S. Treasury bond offers. It currently yields 2.94% with a duration of 20 years. (Remember that duration is a measure of interest rate sensitivity, so together with a bond’s yield, you can calculate the point at which a rate increase would offset the yield you earn — your breakeven point.) In the case of the 30-year Treasury, an entire year’s income (2.94%) would be wiped out if yields were to increase by just 0.15%.
The United States’ Downgrade
The irony is that regardless of the brand of cereal you like — Boehner Puffs or Obama Flakes — The United States will almost certainly be downgraded. Both plans fall short of full fiscal retrenchment, which is the only remedy to stabilize the U.S. debt situation.
I’ve heard doomsayers highlight this shortfall as a huge systemic risk that will force rating-sensitive investors to dump Treasuries en masse, causing credit markets to freeze up and the world to implode.
This is a gross exaggeration. The reality is that the United States Dollar is still the reserve currency, the Fed is a natural backstop, and most rating-sensitive bondholders have already modified their guidelines in reaction to Standard & Poor’s downgrade.
Doves Control Fed
In terms of monetary policy, 2013 will prove to be a challenging year for hawks. The only official dissenter, Jeffrey Lacker, will lose his Federal Open Market Committee seat in 2013 and be replaced by one of the great doves, Charles Evans, who was made famous by what is now known as the Evans rule.
I had identified the Evans rule as a potential change in Fed policy in 2013. I was wrong. It was a 2012 event! The Fed will continue to prime the pump until unemployment hits 6.5%, while it will tolerate inflation up to an unofficial 2.5%.
Positive Momentum Expected
Aside from the fiscal cliff and budgetary woes, the United States is actually faring remarkably well. It seems that Superstorm Sandy didn’t have as big an economic impact on the United States as many forecasters had predicted (I am sure this conclusion is insulting to those who were directly affected, and for this I am sorry).
We also have a reinvigorated housing market, which at 2% of GDP seems trivial, but the equity stored in our homes accounts for most of our net worth.
Through the various wealth effect channels, a robust housing market will improve our collective financial and emotional health, and this, ladies and gentlemen, is not inconsequential; almost 70% of GDP is based on personal consumption. Moreover, the “re-shoring” of manufacturing jobs seems to be gaining traction, and the energy renaissance will further solidify our comparative advantage.
The real question for the United States is twofold: (1) If we are on relatively better footing, how long before our currency strengthens and the positive contribution from our exports turns negative? (2) How long will markets let us solidify our growth trajectory at the expense of our budgets?
Europe: The Treatment Is Worse Than the Disease
Europe is going to take it on the chin this year. The medicine Europeans are taking to fix their economic woes is pushing up unemployment, and GDP growth is forecast to be slightly negative (–0.1%).
That said, many expect Europe to begin to grow by the end of 2013. I have little doubt that Germany will, but Europe is fragmented, and I think 2013 will still be a challenging year for the peripheral countries.
Spain has done what it said it would do, but a lot of their austerity measures are self-defeating, and I see civil unrest and political upsets as the biggest risks to continued progress in Europe. We may very well see Catalonia seceded from Spain, for instance.
The Far East: Lead Boots and Green Shoots
China, once considered the white knight of growth, has been outfitted with lead boots and is spending its political capital on the Senkaku Islands and the oil reserves below them.
But there is some cause for optimism: Early indicators (like electric consumption and railcar utilization) are up, and we have a new, slimmer politburo with Xi Jinping at the helm.
Surprisingly little is known about Xi Jinping’s official leanings. He seems to favor what the Chinese call “inclusive growth,” which targets the growing income disparity among the population. He also advocates for balanced, consumption-driven growth, along with continued enhancements to social welfare programs and an end to the rampant corruption in the Chinese Communist Party. But again, it will take a great many nautical miles to turn the ship that China steers.
The first official event for the new Chinese party isn’t until March, when the National People’s Congress convenes, but we got a sneak peak at the 2013 Central Economic Working Conference. The headline from this event is further government support for urbanization and investment, which will de-emphasize nominal growth targets in favor of “quality growth.” A good recap is available here.
Looking eastward, Japan’s Prime Minister, Shinzo Abe, campaigned and was reelected on a platform of massive quantitative easing (QE). I have my doubts that monetary re-flation will trump structural deflation. There simply aren’t enough ablebodied men in Japan to pick up what the Bank of Japan is putting down.
My suspicion is that this round of QE is simply meant to take aim at the strength of the yen, but Japan is competing against other central banks looking to do the same thing.
An Off-Color Commodity Trade
As China comes back online, we could see commodity prices strengthen somewhat, but by and large, I expect lower global growth, a strengthening dollar, and emerging U.S. energy independence. So, what does all this mean for oil prices? Save for a Middle East disturbance, I expect oil to head lower, which would be a boon for the energy-intensive industries and a double windfall for those industries that use energy inefficiently.
On the one hand, Asian manufacturers have some of the most energy-intensive industries with some of the lowest efficiency scores, so any change in oil prices will have a massive and magnified impact on their operating income. On the other hand, South America has historically been a producer of that same energy. So, a tailwind for one would be a headwind for the other.
It may also make sense to stay exclusively in South and Central America and sniff out an inefficient manufacturer just south of the border. Geographically speaking, these countries are well insulated from Europe and have strong ties to the United States and Canada, two marginally growing economies.
So What Does All This Mean? Make Hay While the Sun Shines
I generally don’t like investing with the grain, but if I’ve learned one thing, it is not to fight the tape. The markets want to send risk assets higher, and although they will never trade in one direction indefinitely, this most recent sell-off has piqued my interest. Give it a little while longer, but this weakness should be bought rather than sold.
Disclaimer: Please note that the content of this site should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute.