ECR Global Financial Markets Report
Thursday, March 18, 2010
INDEX
SUMMARY
For a speed-read version of Transitional period, or the calm before the storm? the report please read the Many economists see this period as a transitional phase from a deep economic decline extracts in the left-hand to a new expansion phase in the world economy. Sentiment and technical indicators margin. warn, however, that the rise in the stock markets from last year onwards has only
been a correction and a continuation of the bear market is in the offing.
From a fundamental point of view, this can easily be substantiated. After all, the recovery of the economy is primarily being supported by fiscal and monetary stimulation. Too rapidly mounting budget deficits and real long-term interest rates could both force the authorities to tighten monetary policy. This will bring the negative effects of debt reduction – which is now being pushed into the background by the stimulation – back to the fore. In our view, stock prices will rise even further in the coming months due to the improved growth outlook for the months ahead and an easy monetary policy on balance worldwide. Implications for the financial markets
With improving growth expectations and rallying stock prices, in the next few months we foresee yields on 10-year US and German Treasuries rising to at least 4.2% and 3.5% respectively. We envisage real interest rates rising even further and, combined with speculation of tighter monetary and fiscal policy, we then expect growth expectations, stock prices and long-term interest rates to fall. As we expect a substantial rise in US growth, EUR/USD could initially fall towards 1.30. After that, we foresee a major correction to 1.42 or higher, followed by a sharp drop towards 1.20 or lower.
TRANSITIONAL PERIOD, OR THE CALM BEFORE THE STORM? There have been few spectacular developments over the past few days and price forming in the financial markets has been calm. The economic figures were therefore in line with the consensus expectation:
In Europe, Greece has largely been the centre of attention. Now that it is clear the country will definitely be assisted if necessary, the mood is less concerned and the euro has stopped falling, for example. In Asia, the figures point to persistent high growth. At the same time, it is becoming clear that the Chinese government wishes to prevent overheating and wants to tighten monetary policy. Despite the highest growth, the Chinese stock market is therefore one of those performing the worst in the world. Additionally, the figures in Japan are also improving and the BoJ has just announced stimulation measures. The picture this presents is one where investors and economists expect growth to pick up worldwide and where figures are reasonably positive. Apart from in China, inflation is not yet rising, so monetary policy will remain easy worldwide. Combined with a (slight) upturn in growth, this constitutes an ideal climate for asset prices. The question now is whether this is a transitional period from a period of substantial shrinkage to a period of widely-supported growth and a self-perpetuating spiral. Or is this period rather the calm before the storm (in other words, we are sliding back into recession) or will growth continue hobbling along. And what, then, are the implications for the financial markets?
Will low inflation and moderate GDP growth really continue? 4 3 2 1 %
Economic figures are moderately positive, but the question is whether this heralds a sustainable recovery or whether it is just the calm before the storm.
In the US, investors and economists are expecting the economy to pick up. Many figures also point in that direction and where figures are disappointing they are being blamed on the abnormally bad winter weather in the early months of this year. These figures could be made up again in the coming months.
0 -1 -2 -3 -4 05
06
07
08
09
10
11
12
13
14
G7, (expected) annual GDP growth G7, (expected) annual rate of inflation Source: IMF / ECR
Back to summary ^
2 / 12
MARKET ANALYSIS FURTHER EXAMINED Before we go into this in detail, we would like to take advantage of the relative calm in the markets to take a step back and look more closely at the way we analyse the economy and the markets. After all, we can quite imagine that you, as the reader, sometimes have the feeling that we view the economy or the markets too negatively when optimism is increasing and too positively when things are going badly. There can be a number of reasons for this: Financial markets are often ahead of economic developments. Sentiment often changes proportional to (stock) prices. The response to stock market highs and lows if often an extremely positive or negative sentiment. An optimistic economic outlook does not necessarily mean rising stock prices.
Consequentially now, after almost a year of virtually uninterrupted rises in stock prices, we can expect the economy to continue recovering. On the other hand, this optimism regarding the economic outlook for the coming months does not mean that we should necessarily assume that stock prices will rise further. China is a prime example here: persistent high growth, but falling stock prices from November onwards, on balance, due to (speculation about) monetary tightening. This is fairly logical, too; according to the theory books, the economy fluctuates between phases of expansion and correction. That correction then creates a healthy foundation for a new expansion phase, etc. On balance, the economy does show a rising line (or, more technically, the trend line has a positive slope). Likewise, the graph for any particular stock index is not a straight upward or downward line, but shows fluctuations.
The difficult thing, however, is to spot a trend reversal coming. Sentiment indicators give no warning. If, for example, you put the S&P 500 graph next to a graph of market sentiment (among investors or brokers, then the two lines show major similarities. That is not surprising, naturally. If rising stock prices are an omen of It is extremely difficult to higher growth, then profits will automatically improve and stock prices can rise predict a trend reversal. further. But a trend reversal almost always takes place just when sentiment reaches an extreme level. And those are the moments at which most analysts and economists also become extremely positive (or negative). From this point of view, it’s no wonder virtually nobody saw the credit crisis coming. If sentiment is extremely positive or negative, we should be suspect a trend reversal.
One of the major reasons is the tendency to extrapolate the present and the recent past to the future. Strange, as the economy and the markets can’t be expressed in straight lines, but understandable nevertheless. No one knows exactly what the future holds and psychological research has shows that people are simply unable or unwilling to think easily in terms of (radical) change. In other words, sentiment confirms the trend rather than having and predictive value. Sentiment can be used the other way around, though. In other words, if sentiment is extremely positive, then watch out for a swing to falling stock prices and vice versa.
3 / 12
15
16 00 15 00 14 00 13 00 12 00 11 00 10 00 9 00 8 00 7 00 6 00
S entim ent
5 Net balance
-5 -15 -25 -35 -45 -55 07
08
09
Index
W h en sen tim en t takes ex trem e valu es a trend reve rs al is very likely
10
U S , sentix, investors sentim ent (lhs) U S , S & P 500 C om posite P rice R eturn (rhs) S o urce: R eu ters E coW in / E C R
A swing is easier to predict with a combination of fundamental and technical analysis.
In the past, technical analysis and indicators have proved to be better able to predict a trend reversal. Certainty can’t be achieved through technical analysis either, unfortunately, but there is more chance of spotting a trend reversal than on the basis of fundamental analysis. We therefore always combine fundamental and technical analysis and signs from the market. A combination that works best for us and at least makes us aware of the possibility of a trend reversal. We may, therefore, indeed be slightly more negative when it seems that positivism is only increasing and actually more positive when virtually nobody else is positive any longer. One disadvantage, however, is that extreme sentiment can sometimes persist longer than expected. When sentiment is extremely positive, then and uptrend may, for instance, persist longer than expected.
Back to summary ^
WARNING SIGNALS FOR A TREND REVERSAL IN STOCK PRICES Economists and analysts generally expect the rise in stock prices to continue.
Stock prices are a good example here. Sine last year, stock prices have risen at an unprecedented pace and most economists and analysts expect this recovery to continue, aside from interim corrections: The economic recovery is continuing and monetary policy remains easy. This week, the Fed announced that it will not be raising interest rates for an extended period. In view of the mounting unemployment, (threat of) deflation and weak domestic recovery, the Bank of Japan and the ECB will (probably) be more inclined to ease rather than tighten monetary policy. The productivity rise, in the US in particular, is high; company balance sheets are generally looking healthy (healthier than those in the governmental and consumer sectors) and profits remain high, despite disappointing growth.
4 / 12
Doubt about the quality of the recovery of stock prices is fairly normal after an economic crisis. It is never clear at the beginning where the economic recovery will come from, but in the past it always came and stock prices anticipate that. This is where the expression ‘stocks climb a wall of worries/fear’ comes from. Finally, as many economists are putting it, there is still a lot of money on the side line. As long as yields on stocks remain positive, growth picks up and short-term interest rates remain close to 0%, more and more investors will buy stocks.
In creased prod uctivity and exceptionally lo w rates g ive rise to fu rth er m arke t o p tim is m 9 8 7
P roductivity
6 %
5 4 3 2 1 0 -1 07 08 09 10 U S , output per hour of all persons, nonfarm , chg. Y oY U S , F ed F unds T arget R ate S ou rce : R e ute rs E co W in / E C R
Technical indicators are giving warning signals, however.
Technical indicators are starting to give off warning signals, however, that a major trend reversal is in the offing: Various surveys amongst investors have shown that the percentage of bears is extremely low, from a historical point of view (between 5% and 25% depending on the survey). In March 2009, the percentage of bears was between 90% and 70%, depending on the survey. The rise from March 2009 can be seen as a completed correction, in terms of both time and structure. Leaving aside the timing of a correction or trend reversal, on the basis of fundamental analysis we are quite happy with the chart-technical view that the rise in stock prices from March 2009 has been a correction rather than the start of a new bull market.
The rise from March 2009 looks very much like a major correction and not the beginning of a new bull market.
The major reason, in our view, is that in recent decades periods of economic recovery were almost always largely based on a combination of rising asset prices and credit. This allowed US consumers, in particular, to consume more and more without incomes rising correspondingly. Consumption was also the major growth motor in the US. That motor has seized up now, however. Rises in housing prices are negligible, house building remains low and the number transactions likewise. The housing market is also largely being kept on its feet by the government. Public finances are in such a poor
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state, however, that the government will not be able to ensure a sustainable recovery. That will require rising employment and increased lending. That is not happening at the moment. The recovery of the economy and the labour market may have been delayed by the abnormally bad winter weather, but employment and lending will have to improve before long, anyway. After all, if public finances are not to get out of hand, the government will have to start tightening fiscal policy at the end of this year or early next year. Otherwise, the risk of the US credit rating being downgraded is high, which will cause rising real interest rates and the US will be worse off than ever. For the economy this is negative. Probably only more jobs and lending can then prevent the economy from sliding again. Incidentally, more investments and exports could generate growth. Both these sectors are small, though, in comparison with the consumption sector. Moreover, it takes time to build up an export industry and it is doubtful whether there is much need for more investment as long as the recovery of the US, European and Japanese economies remains slow. There is still a high level of overcapacity worldwide.
Alth o u g h m o re e x p o rt a n d in ve s tm en t c o u ld d rive g ro w th a b it, n o m ira c le s s h o u ld b e e x p e c te d fro m it 80 70 60
C onsum ption
%
50 40 30
Investm ent
20 10 0 00
01
02
03
04
05
06
07
08
09
U S , investm ent as % of G D P U S , export as % of G D P U S , consum ption as % of G D P S o urce: R eu ters E coW in / E C R
It will be a number of years before growth in Asia and the restoration of trade balances will take the world economy to a higher level.
Europe and Japan are in more or less the boat where growth is concerned. A decline in lending and employment is seriously inhibiting growth. So far, fiscal and monetary easing, plus an upturn in exports from Japan and Germany has prompted a (cautious) recovery of growth. The question is, however, how long this can be maintained. Rapidly-deteriorating public finances are a cause of concern and fiscal tightening in the coming years is looming in Europe, in any event. Hopes for a full recovery of the world economy are therefore partly pinned on persistent growth in China (exports to the country are fast increasing) and on countries that previously has a large surplus on the current account – Germany, China and Japan – consuming more. We feel it will be a number of years before this lifts the world economy to a higher level. In short, we expect neither a real recovery nor a decline back into recession. This means persistent low growth with persistently high budget deficits. This, in turn, will result in high (real) interest rates and falling profits. We therefore envisage the stock market rally coming to an end. Back to summary ^
6 / 12
FIRST PRUNE BACK, THEN PLUCK THE FRUITS For a sustainable recovery we first have to reduce debts.
Before growth can get off the ground sustainably – without fiscal or monetary stimulation – the debt mountain first needs to be reduced. In earlier reports, we already mentioned that a large proportion of growth in recent decades is attributable to monetary and fiscal stimulation of the economy in not only bad but also good times. This resulted in an increase in public debts, but also the indebtedness of consumers, who saw their assets continually appreciating due to falling interest rates and easy monetary policy and started borrowing increasingly against them to consume more.
Debts are primarily created by consuming more.
Borrowing for (government) consumption produces excellent results in the short term, but is ultimately bad for the economy. The loan has to be repaid at a later stage and, in the meantime, interest payments use up money that could otherwise have been used for consumption. Borrowing money for investment, incidentally, has the opposite effect and, on balance, is good for the economy in the long term.
%
In th e decade preceding th e crisis, borro w ing w as in creased to finance consum ption, no t in vestm ents 35 .0 32 .5 30 .0 27 .5 25 .0 22 .5 20 .0 17 .5 15 .0 12 .5 10 .0 95
N et borrow ing
00
05
U S , investm ents as % of G D P U S , total net borrow ing S ou rce: R eu ters E co W in / E C R
Now that the collateral for many loans (property and stocks, but also wage incomes and tax revenue) is worth less, despite lower interest rates the burden of interest payments is weighing more heavily and the pressure to repay loans is increasing. This is the bitter pill we have to take and, in our view, it includes a drop in asset prices. The authorities are attempting to prevent and delay this process as far as possible, however, as the repayment of debts weighs heavily on growth. This has created a situation where – in the US, for example – the debt mountain in the private sector is shrinking rapidly, but in the government sector it is growing swiftly. Many economists feel the government constitutes too small a part of the economy to prevent further shrinkage of the debt mountain, however. What’s more, as we already mentioned, there is increasing pressure on the government not to allow public debt to mount too high. Once consumptive credit has been reduced, the world economy can expand healthily again.
Incidentally, as soon as this process of pruning consumptive debts is behind us, a healthy foundation will have been laid for strong expansion of the world economy. Growth in the working population, investments and labour productivity are the underlying growth motor. Asia, South America and Africa have the best outlook in this respect (certainly where the working population is concerned, but also because they
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will be able to catch up in investments and efficiency). We see the more mature markets, such as Europe, the US and Japan, benefiting from this in the form of higher exports, but also higher returns on capital invested in these markets. This will result in a new bull market in shares in the long term, in our view.
USD (thousand billions)
As in terest p aym en ts w eig h m o re h eaviliy o n in com e, th e private sector has started to repay debt 43 42 41 40 39 38 37 36 35 34 33 32 31 30 05 06 07 08 09 U S , total private debt outstanding (rhs) S o urce: R eute rs E co w in / E C R
Back to summary ^
COMPLICATED TIMING First, we expect the bear market that began in 2007 to resume.
A definite resumption of this bear market would seem to require a breakout in long-term interest rates.
As we already said, this is something for the long term. For the moment, we first have to get through a bear market, in our opinion. No one can predict the timing of the market perfectly, unfortunately. The most we can achieve is to predict as closely as possible the point where a trend reversal will take place And even that is more successful one time or period than another. In the present case, timing is a problem again. We estimate the chance of the rise from March last year being an upward correction at around 80%. The question is then when the bear market that began in 2007 will resume. It could happen at any time, but a further rise first is equally possible (the S&P 500 Index could then rise towards 1250 – 1300). At the moment, we feel the chance of stock prices first rising further is slightly higher than 50%. We foresee enthusiasm regarding rising growth increasing in coming months. Then, we expect speculation on monetary tightening to increase, but the two could be parallel initially. It will take time before fears of a tighter policy predominate and stock prices fall. Monetary policy will remain easy, even though more and more central banks are indicating that they will tighten monetary policy (further), particularly in Asia. At the same time, banks remain reluctant to lend, so on balance a great deal of liquidity remains available for higher risk investments.
8 / 12
For the US, we expect the turning point to come once 10-year yields break out above 3.85%.
Stock prices also continue to anticipate economic growth.
Possibly more important is the fact a breakout in long-term interest rates is needed to herald a new bear market. Governments and central banks will do everything possible to prevent a negative deflationary spiral as a result of debt repayment. As soon as the economy threatens to slide again, governments will therefore ease fiscal policy and central banks will be under great pressure to buy more bonds and Treasuries, like in Japan. At some point, fears of inflation policy or excessive budget deficits will prompt a further rise in real long-term interest rates. This is ultimately negative for stocks. We expect this turning point to be reached as soon as the yield on 10-year Treasuries breaks out above the 3.85% and rises towards 4.5%, in the US in any event. For yields on German 10-year Treasuries, 3.5% would seem a significant level to look out for. We are not at that stage yet, however, and we have recently seen downward pressure on long-term interest rates and the premiums on credit default swaps for Treasuries (CDSs are an insurance against default). Going back to the beginning of this report, we feel the increasing optimism in the stock markets and in respect of the growth outlook is the calm before the storm rather than a transitional period to a new phase of strong economic expansion. That calm could last for while, though. Incidentally, we feel the stock markets will continue to anticipate growth developments. If stock prices do, indeed, only start falling in a few weeks to months then, quite possibly, we can expect growth up to the end of this year.
Back to summary ^
IMPLICATIONS FOR THE FINANCIAL MARKETS Interest and currency rates and reasonably dependent on the development of stock prices. At least from the point of view that as soon as investors become more positive about the economy they buy stock and they sell them once pessimism increases. When optimism increases, long-term interest rates are generally under upward pressure (due to higher real interest rates and rising inflation expectations) and EUR/USD rises. After all, more dollars are then borrowed for investing in assets with a higher return – carry trades – which increases the supply of dollars. We foresee long-term interest rates rising due to improved growth expectations, inflation risks and speculations of monetary tightening.
We envisage yields on 10-year US and German Treasuries (now around 3.65% and 3.10% respectively) rising in the coming months. After all, there is a fair chance that the growth outlook will improve, stock prices will rise further and inflation expectations and speculation on a tighter monetary policy will grow in response. Moreover, there are increasing concerns about the tenability of public finances at both a local and federal level. In recent weeks, the credit rating agencies Moody’s and S&P have warned the US, for example, of a downgrade if they fail to put their public finances in order. Growing inflation expectations might seem at odds with the continual threat of a deflationary spiral due to the shrinkage of the debt mountain. With the economy and employment picking up, however, it is probably only a question of time before lending increases again. As the Fed has doubled the (basic) money supply over the past few years, the combination of more lending, recovering growth and large-scale fiscal stimulation could be a dangerous cocktail, causing rapidly-rising inflation (expectations).
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F o r n o w th e risk o f in flatio n is lo w , b u t o n ce cre d it expands, prices m ig h t go ballistic 44 .0 42 .0
2.0 0
40 .0
M onetary base
1.7 5
38 .0 36 .0
1.5 0
%
USD (thousand billions)
2.2 5
34 .0 1.2 5
32 .0 30 .0
1.0 0
28 .0
0.7 5
26 .0 06
07
08
09
U S , adjusted m onetary base (lhs) U S , N F IB , borrow ing needs satisfied (rhs) S o urce: R eu ters E coW in / E C R
At levels above 4.2% we expect the rise in US interest rates to come to an end.
We expect the rise in long-term interest rates to come to an end as soon as the growth outlook and stock prices come under renewed downward pressure (we don’t feel very positive about the growth outlook anyway, let alone if interest rates rise). In our opinion, however, the chance is that this will only happen once yields on 10-year US Treasuries rise to 4.2% and higher – with 3.85% as a significant resistance level – and those on 10-year German Treasuries to above 3.5%. Incidentally, we foresee long-term interest rates rising more rapidly in the US than in Germany, due to a rosier growth outlook in the US (also see our earlier reports). Despite the fact that we feel there is a strong chance of stock prices rising further, over the coming weeks to months we expect EUR/USD to fall towards 1.30, because: The growth differences in the favour of the US will persist in the coming months The problems concerning Greek public finances will continue longer than expected, which is undermining the euro
We foresee EUR/USD falling towards 1.30 due to speculation on US interest rate rises and problems in Europe.
We therefore expect speculation on interest rate rises to grow first in the US. In Europe, on the other hand, there is more likely to be speculation on an easier rather than a tighter monetary policy. The recovery is not really getting off the ground and fiscal tightening – to ensure that public finances again comply with the criteria of the Growth and Stability Pact – is hanging like a black cloud above the European economy. On the other hand, in this election year the US will be more inclined to implement further fiscal stimulation. The tug-of-war concerning Greece is not, in our view, so much about the maximum of 50 billion euros the country will require over the coming months, but more about the sustainability of European public finances in general. Now that Germany, for example, also wants (or has) to start tightening policy next year, the political resistance to helping the weaker euro brothers is great. This is not good for confidence in the euro, to start with, but it will also put the ECB under pressure to soften the fiscal tightening by maintaining an easy monetary policy or even easing policy. We expect the fall in EUR/USD to come to an end around 1.30 (although, if the US economy has recovered more strongly than we now foresee, the rate could slide further towards 1.25). Higher (real) interest rates and speculation on a tighter monetary and fiscal policy will then knock back stocks and growth expectations. We
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then expect the speculation on monetary tightening in the US to turn into speculation on monetary easing. By that time, concerns will also be growing with regard to US public finances, particularly at a more local level. The US is highly dependant on foreign capital. Any damage to its status as a country with big liquidity markets and After that, we expect doubts concerning the US strong creditworthiness could have negative consequences for the dollar. China, for to grow and EUR/USD to example, is increasingly questioning the reliability of the US as a solid investment, also for political reasons. rise towards 1.42 and possibly even 1.47.
We therefore envisage EUR/USD experiencing a major correction later this year (from 1.30 - 1.25) towards 1.42. Should Europe, in the meantime, arrive at a more structural solution for preventing the kind of problems arising in Greece at the moment, then EUR/USD could rise to 1.47. The more trouble the Greek problems cause the European economy and the euro, the more chance of a structural solution. The long-term trend is towards 1.20, though.
The major movement of EUR/USD in the coming quarters, however, remains a fall towards 1.20 or lower, in our view. This, as we have explained in earlier reports, is the result of the reversal of dollar-funded carry trades and more safe haven flows towards the dollar as soon as the asset markets resume the bear market that started in 2007. Moreover, in the long term we foresee the dollar benefiting from a more competitive and flexible American economy. Finally The current economy is characterised and highly dependent on the historically unprecedented scope of fiscal and monetary stimulation. This makes it far more difficult to analyse the economy and financial markets based on past knowledge and experience. Due to the strong stimulation of the Chinese economy, for example, according to an increasing number of economists, it is threatening to overheat and a (property) bubble if forming in China that could burst at any moment. If this does, indeed, happen in the near future then the scenario of stock prices and interest rates rising further is quite unrealistic and the dollar could appreciate far more quickly than we expect now. Politicians are another wild card. With the recovery only taking off slowly and unemployment mounting in many countries, civil unrest is increasing. Politicians are therefore inclined to give in to the often populist tone of domestic criticism and lose sight of the bigger picture. Our political department helps us to analyse these changes properly, but that does not alter the fact that political developments can cause many a surprise. In other words, we are fast approaching an era that has little precedent in history, which demands extra attentiveness.
EUR / USD
EUR / JPY 1.525
140.0
1.500
137.5 135.0
1.475
132.5 1.450 130.0 1.425 127.5 1.400
125.0
1.375
Sep
Nov 09
Jan
Mar
1.350
10 Source: Reuters EcoWin / ECR
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122.5 Sep
Nov 09
Jan
Mar
120.0
10 Source: Reuters EcoWin / ECR
USD / JPY 94 93 92 91 90 89 88 87 Sep
Nov 09
Jan
Mar
86
10 Source: Reuters EcoWin / ECR
Back to summary ^
12 / 12
INDEX
SUMMARY
For a speed-read version of Transitional period, or the calm before the storm? the report please read the Many economists see this period as a transitional phase from a deep economic decline extracts in the left-hand to a new expansion phase in the world economy. Sentiment and technical indicators margin. warn, however, that the rise in the stock markets from last year onwards has only
been a correction and a continuation of the bear market is in the offing.
From a fundamental point of view, this can easily be substantiated. After all, the recovery of the economy is primarily being supported by fiscal and monetary stimulation. Too rapidly mounting budget deficits and real long-term interest rates could both force the authorities to tighten monetary policy. This will bring the negative effects of debt reduction – which is now being pushed into the background by the stimulation – back to the fore. In our view, stock prices will rise even further in the coming months due to the improved growth outlook for the months ahead and an easy monetary policy on balance worldwide. Implications for the financial markets
With improving growth expectations and rallying stock prices, in the next few months we foresee yields on 10-year US and German Treasuries rising to at least 4.2% and 3.5% respectively. We envisage real interest rates rising even further and, combined with speculation of tighter monetary and fiscal policy, we then expect growth expectations, stock prices and long-term interest rates to fall. As we expect a substantial rise in US growth, EUR/USD could initially fall towards 1.30. After that, we foresee a major correction to 1.42 or higher, followed by a sharp drop towards 1.20 or lower.
TRANSITIONAL PERIOD, OR THE CALM BEFORE THE STORM? There have been few spectacular developments over the past few days and price forming in the financial markets has been calm. The economic figures were therefore in line with the consensus expectation:
In Europe, Greece has largely been the centre of attention. Now that it is clear the country will definitely be assisted if necessary, the mood is less concerned and the euro has stopped falling, for example. In Asia, the figures point to persistent high growth. At the same time, it is becoming clear that the Chinese government wishes to prevent overheating and wants to tighten monetary policy. Despite the highest growth, the Chinese stock market is therefore one of those performing the worst in the world. Additionally, the figures in Japan are also improving and the BoJ has just announced stimulation measures. The picture this presents is one where investors and economists expect growth to pick up worldwide and where figures are reasonably positive. Apart from in China, inflation is not yet rising, so monetary policy will remain easy worldwide. Combined with a (slight) upturn in growth, this constitutes an ideal climate for asset prices. The question now is whether this is a transitional period from a period of substantial shrinkage to a period of widely-supported growth and a self-perpetuating spiral. Or is this period rather the calm before the storm (in other words, we are sliding back into recession) or will growth continue hobbling along. And what, then, are the implications for the financial markets?
Will low inflation and moderate GDP growth really continue? 4 3 2 1 %
Economic figures are moderately positive, but the question is whether this heralds a sustainable recovery or whether it is just the calm before the storm.
In the US, investors and economists are expecting the economy to pick up. Many figures also point in that direction and where figures are disappointing they are being blamed on the abnormally bad winter weather in the early months of this year. These figures could be made up again in the coming months.
0 -1 -2 -3 -4 05
06
07
08
09
10
11
12
13
14
G7, (expected) annual GDP growth G7, (expected) annual rate of inflation Source: IMF / ECR
Back to summary ^
2 / 12
MARKET ANALYSIS FURTHER EXAMINED Before we go into this in detail, we would like to take advantage of the relative calm in the markets to take a step back and look more closely at the way we analyse the economy and the markets. After all, we can quite imagine that you, as the reader, sometimes have the feeling that we view the economy or the markets too negatively when optimism is increasing and too positively when things are going badly. There can be a number of reasons for this: Financial markets are often ahead of economic developments. Sentiment often changes proportional to (stock) prices. The response to stock market highs and lows if often an extremely positive or negative sentiment. An optimistic economic outlook does not necessarily mean rising stock prices.
Consequentially now, after almost a year of virtually uninterrupted rises in stock prices, we can expect the economy to continue recovering. On the other hand, this optimism regarding the economic outlook for the coming months does not mean that we should necessarily assume that stock prices will rise further. China is a prime example here: persistent high growth, but falling stock prices from November onwards, on balance, due to (speculation about) monetary tightening. This is fairly logical, too; according to the theory books, the economy fluctuates between phases of expansion and correction. That correction then creates a healthy foundation for a new expansion phase, etc. On balance, the economy does show a rising line (or, more technically, the trend line has a positive slope). Likewise, the graph for any particular stock index is not a straight upward or downward line, but shows fluctuations.
The difficult thing, however, is to spot a trend reversal coming. Sentiment indicators give no warning. If, for example, you put the S&P 500 graph next to a graph of market sentiment (among investors or brokers, then the two lines show major similarities. That is not surprising, naturally. If rising stock prices are an omen of It is extremely difficult to higher growth, then profits will automatically improve and stock prices can rise predict a trend reversal. further. But a trend reversal almost always takes place just when sentiment reaches an extreme level. And those are the moments at which most analysts and economists also become extremely positive (or negative). From this point of view, it’s no wonder virtually nobody saw the credit crisis coming. If sentiment is extremely positive or negative, we should be suspect a trend reversal.
One of the major reasons is the tendency to extrapolate the present and the recent past to the future. Strange, as the economy and the markets can’t be expressed in straight lines, but understandable nevertheless. No one knows exactly what the future holds and psychological research has shows that people are simply unable or unwilling to think easily in terms of (radical) change. In other words, sentiment confirms the trend rather than having and predictive value. Sentiment can be used the other way around, though. In other words, if sentiment is extremely positive, then watch out for a swing to falling stock prices and vice versa.
3 / 12
15
16 00 15 00 14 00 13 00 12 00 11 00 10 00 9 00 8 00 7 00 6 00
S entim ent
5 Net balance
-5 -15 -25 -35 -45 -55 07
08
09
Index
W h en sen tim en t takes ex trem e valu es a trend reve rs al is very likely
10
U S , sentix, investors sentim ent (lhs) U S , S & P 500 C om posite P rice R eturn (rhs) S o urce: R eu ters E coW in / E C R
A swing is easier to predict with a combination of fundamental and technical analysis.
In the past, technical analysis and indicators have proved to be better able to predict a trend reversal. Certainty can’t be achieved through technical analysis either, unfortunately, but there is more chance of spotting a trend reversal than on the basis of fundamental analysis. We therefore always combine fundamental and technical analysis and signs from the market. A combination that works best for us and at least makes us aware of the possibility of a trend reversal. We may, therefore, indeed be slightly more negative when it seems that positivism is only increasing and actually more positive when virtually nobody else is positive any longer. One disadvantage, however, is that extreme sentiment can sometimes persist longer than expected. When sentiment is extremely positive, then and uptrend may, for instance, persist longer than expected.
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WARNING SIGNALS FOR A TREND REVERSAL IN STOCK PRICES Economists and analysts generally expect the rise in stock prices to continue.
Stock prices are a good example here. Sine last year, stock prices have risen at an unprecedented pace and most economists and analysts expect this recovery to continue, aside from interim corrections: The economic recovery is continuing and monetary policy remains easy. This week, the Fed announced that it will not be raising interest rates for an extended period. In view of the mounting unemployment, (threat of) deflation and weak domestic recovery, the Bank of Japan and the ECB will (probably) be more inclined to ease rather than tighten monetary policy. The productivity rise, in the US in particular, is high; company balance sheets are generally looking healthy (healthier than those in the governmental and consumer sectors) and profits remain high, despite disappointing growth.
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Doubt about the quality of the recovery of stock prices is fairly normal after an economic crisis. It is never clear at the beginning where the economic recovery will come from, but in the past it always came and stock prices anticipate that. This is where the expression ‘stocks climb a wall of worries/fear’ comes from. Finally, as many economists are putting it, there is still a lot of money on the side line. As long as yields on stocks remain positive, growth picks up and short-term interest rates remain close to 0%, more and more investors will buy stocks.
In creased prod uctivity and exceptionally lo w rates g ive rise to fu rth er m arke t o p tim is m 9 8 7
P roductivity
6 %
5 4 3 2 1 0 -1 07 08 09 10 U S , output per hour of all persons, nonfarm , chg. Y oY U S , F ed F unds T arget R ate S ou rce : R e ute rs E co W in / E C R
Technical indicators are giving warning signals, however.
Technical indicators are starting to give off warning signals, however, that a major trend reversal is in the offing: Various surveys amongst investors have shown that the percentage of bears is extremely low, from a historical point of view (between 5% and 25% depending on the survey). In March 2009, the percentage of bears was between 90% and 70%, depending on the survey. The rise from March 2009 can be seen as a completed correction, in terms of both time and structure. Leaving aside the timing of a correction or trend reversal, on the basis of fundamental analysis we are quite happy with the chart-technical view that the rise in stock prices from March 2009 has been a correction rather than the start of a new bull market.
The rise from March 2009 looks very much like a major correction and not the beginning of a new bull market.
The major reason, in our view, is that in recent decades periods of economic recovery were almost always largely based on a combination of rising asset prices and credit. This allowed US consumers, in particular, to consume more and more without incomes rising correspondingly. Consumption was also the major growth motor in the US. That motor has seized up now, however. Rises in housing prices are negligible, house building remains low and the number transactions likewise. The housing market is also largely being kept on its feet by the government. Public finances are in such a poor
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state, however, that the government will not be able to ensure a sustainable recovery. That will require rising employment and increased lending. That is not happening at the moment. The recovery of the economy and the labour market may have been delayed by the abnormally bad winter weather, but employment and lending will have to improve before long, anyway. After all, if public finances are not to get out of hand, the government will have to start tightening fiscal policy at the end of this year or early next year. Otherwise, the risk of the US credit rating being downgraded is high, which will cause rising real interest rates and the US will be worse off than ever. For the economy this is negative. Probably only more jobs and lending can then prevent the economy from sliding again. Incidentally, more investments and exports could generate growth. Both these sectors are small, though, in comparison with the consumption sector. Moreover, it takes time to build up an export industry and it is doubtful whether there is much need for more investment as long as the recovery of the US, European and Japanese economies remains slow. There is still a high level of overcapacity worldwide.
Alth o u g h m o re e x p o rt a n d in ve s tm en t c o u ld d rive g ro w th a b it, n o m ira c le s s h o u ld b e e x p e c te d fro m it 80 70 60
C onsum ption
%
50 40 30
Investm ent
20 10 0 00
01
02
03
04
05
06
07
08
09
U S , investm ent as % of G D P U S , export as % of G D P U S , consum ption as % of G D P S o urce: R eu ters E coW in / E C R
It will be a number of years before growth in Asia and the restoration of trade balances will take the world economy to a higher level.
Europe and Japan are in more or less the boat where growth is concerned. A decline in lending and employment is seriously inhibiting growth. So far, fiscal and monetary easing, plus an upturn in exports from Japan and Germany has prompted a (cautious) recovery of growth. The question is, however, how long this can be maintained. Rapidly-deteriorating public finances are a cause of concern and fiscal tightening in the coming years is looming in Europe, in any event. Hopes for a full recovery of the world economy are therefore partly pinned on persistent growth in China (exports to the country are fast increasing) and on countries that previously has a large surplus on the current account – Germany, China and Japan – consuming more. We feel it will be a number of years before this lifts the world economy to a higher level. In short, we expect neither a real recovery nor a decline back into recession. This means persistent low growth with persistently high budget deficits. This, in turn, will result in high (real) interest rates and falling profits. We therefore envisage the stock market rally coming to an end. Back to summary ^
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FIRST PRUNE BACK, THEN PLUCK THE FRUITS For a sustainable recovery we first have to reduce debts.
Before growth can get off the ground sustainably – without fiscal or monetary stimulation – the debt mountain first needs to be reduced. In earlier reports, we already mentioned that a large proportion of growth in recent decades is attributable to monetary and fiscal stimulation of the economy in not only bad but also good times. This resulted in an increase in public debts, but also the indebtedness of consumers, who saw their assets continually appreciating due to falling interest rates and easy monetary policy and started borrowing increasingly against them to consume more.
Debts are primarily created by consuming more.
Borrowing for (government) consumption produces excellent results in the short term, but is ultimately bad for the economy. The loan has to be repaid at a later stage and, in the meantime, interest payments use up money that could otherwise have been used for consumption. Borrowing money for investment, incidentally, has the opposite effect and, on balance, is good for the economy in the long term.
%
In th e decade preceding th e crisis, borro w ing w as in creased to finance consum ption, no t in vestm ents 35 .0 32 .5 30 .0 27 .5 25 .0 22 .5 20 .0 17 .5 15 .0 12 .5 10 .0 95
N et borrow ing
00
05
U S , investm ents as % of G D P U S , total net borrow ing S ou rce: R eu ters E co W in / E C R
Now that the collateral for many loans (property and stocks, but also wage incomes and tax revenue) is worth less, despite lower interest rates the burden of interest payments is weighing more heavily and the pressure to repay loans is increasing. This is the bitter pill we have to take and, in our view, it includes a drop in asset prices. The authorities are attempting to prevent and delay this process as far as possible, however, as the repayment of debts weighs heavily on growth. This has created a situation where – in the US, for example – the debt mountain in the private sector is shrinking rapidly, but in the government sector it is growing swiftly. Many economists feel the government constitutes too small a part of the economy to prevent further shrinkage of the debt mountain, however. What’s more, as we already mentioned, there is increasing pressure on the government not to allow public debt to mount too high. Once consumptive credit has been reduced, the world economy can expand healthily again.
Incidentally, as soon as this process of pruning consumptive debts is behind us, a healthy foundation will have been laid for strong expansion of the world economy. Growth in the working population, investments and labour productivity are the underlying growth motor. Asia, South America and Africa have the best outlook in this respect (certainly where the working population is concerned, but also because they
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will be able to catch up in investments and efficiency). We see the more mature markets, such as Europe, the US and Japan, benefiting from this in the form of higher exports, but also higher returns on capital invested in these markets. This will result in a new bull market in shares in the long term, in our view.
USD (thousand billions)
As in terest p aym en ts w eig h m o re h eaviliy o n in com e, th e private sector has started to repay debt 43 42 41 40 39 38 37 36 35 34 33 32 31 30 05 06 07 08 09 U S , total private debt outstanding (rhs) S o urce: R eute rs E co w in / E C R
Back to summary ^
COMPLICATED TIMING First, we expect the bear market that began in 2007 to resume.
A definite resumption of this bear market would seem to require a breakout in long-term interest rates.
As we already said, this is something for the long term. For the moment, we first have to get through a bear market, in our opinion. No one can predict the timing of the market perfectly, unfortunately. The most we can achieve is to predict as closely as possible the point where a trend reversal will take place And even that is more successful one time or period than another. In the present case, timing is a problem again. We estimate the chance of the rise from March last year being an upward correction at around 80%. The question is then when the bear market that began in 2007 will resume. It could happen at any time, but a further rise first is equally possible (the S&P 500 Index could then rise towards 1250 – 1300). At the moment, we feel the chance of stock prices first rising further is slightly higher than 50%. We foresee enthusiasm regarding rising growth increasing in coming months. Then, we expect speculation on monetary tightening to increase, but the two could be parallel initially. It will take time before fears of a tighter policy predominate and stock prices fall. Monetary policy will remain easy, even though more and more central banks are indicating that they will tighten monetary policy (further), particularly in Asia. At the same time, banks remain reluctant to lend, so on balance a great deal of liquidity remains available for higher risk investments.
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For the US, we expect the turning point to come once 10-year yields break out above 3.85%.
Stock prices also continue to anticipate economic growth.
Possibly more important is the fact a breakout in long-term interest rates is needed to herald a new bear market. Governments and central banks will do everything possible to prevent a negative deflationary spiral as a result of debt repayment. As soon as the economy threatens to slide again, governments will therefore ease fiscal policy and central banks will be under great pressure to buy more bonds and Treasuries, like in Japan. At some point, fears of inflation policy or excessive budget deficits will prompt a further rise in real long-term interest rates. This is ultimately negative for stocks. We expect this turning point to be reached as soon as the yield on 10-year Treasuries breaks out above the 3.85% and rises towards 4.5%, in the US in any event. For yields on German 10-year Treasuries, 3.5% would seem a significant level to look out for. We are not at that stage yet, however, and we have recently seen downward pressure on long-term interest rates and the premiums on credit default swaps for Treasuries (CDSs are an insurance against default). Going back to the beginning of this report, we feel the increasing optimism in the stock markets and in respect of the growth outlook is the calm before the storm rather than a transitional period to a new phase of strong economic expansion. That calm could last for while, though. Incidentally, we feel the stock markets will continue to anticipate growth developments. If stock prices do, indeed, only start falling in a few weeks to months then, quite possibly, we can expect growth up to the end of this year.
Back to summary ^
IMPLICATIONS FOR THE FINANCIAL MARKETS Interest and currency rates and reasonably dependent on the development of stock prices. At least from the point of view that as soon as investors become more positive about the economy they buy stock and they sell them once pessimism increases. When optimism increases, long-term interest rates are generally under upward pressure (due to higher real interest rates and rising inflation expectations) and EUR/USD rises. After all, more dollars are then borrowed for investing in assets with a higher return – carry trades – which increases the supply of dollars. We foresee long-term interest rates rising due to improved growth expectations, inflation risks and speculations of monetary tightening.
We envisage yields on 10-year US and German Treasuries (now around 3.65% and 3.10% respectively) rising in the coming months. After all, there is a fair chance that the growth outlook will improve, stock prices will rise further and inflation expectations and speculation on a tighter monetary policy will grow in response. Moreover, there are increasing concerns about the tenability of public finances at both a local and federal level. In recent weeks, the credit rating agencies Moody’s and S&P have warned the US, for example, of a downgrade if they fail to put their public finances in order. Growing inflation expectations might seem at odds with the continual threat of a deflationary spiral due to the shrinkage of the debt mountain. With the economy and employment picking up, however, it is probably only a question of time before lending increases again. As the Fed has doubled the (basic) money supply over the past few years, the combination of more lending, recovering growth and large-scale fiscal stimulation could be a dangerous cocktail, causing rapidly-rising inflation (expectations).
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F o r n o w th e risk o f in flatio n is lo w , b u t o n ce cre d it expands, prices m ig h t go ballistic 44 .0 42 .0
2.0 0
40 .0
M onetary base
1.7 5
38 .0 36 .0
1.5 0
%
USD (thousand billions)
2.2 5
34 .0 1.2 5
32 .0 30 .0
1.0 0
28 .0
0.7 5
26 .0 06
07
08
09
U S , adjusted m onetary base (lhs) U S , N F IB , borrow ing needs satisfied (rhs) S o urce: R eu ters E coW in / E C R
At levels above 4.2% we expect the rise in US interest rates to come to an end.
We expect the rise in long-term interest rates to come to an end as soon as the growth outlook and stock prices come under renewed downward pressure (we don’t feel very positive about the growth outlook anyway, let alone if interest rates rise). In our opinion, however, the chance is that this will only happen once yields on 10-year US Treasuries rise to 4.2% and higher – with 3.85% as a significant resistance level – and those on 10-year German Treasuries to above 3.5%. Incidentally, we foresee long-term interest rates rising more rapidly in the US than in Germany, due to a rosier growth outlook in the US (also see our earlier reports). Despite the fact that we feel there is a strong chance of stock prices rising further, over the coming weeks to months we expect EUR/USD to fall towards 1.30, because: The growth differences in the favour of the US will persist in the coming months The problems concerning Greek public finances will continue longer than expected, which is undermining the euro
We foresee EUR/USD falling towards 1.30 due to speculation on US interest rate rises and problems in Europe.
We therefore expect speculation on interest rate rises to grow first in the US. In Europe, on the other hand, there is more likely to be speculation on an easier rather than a tighter monetary policy. The recovery is not really getting off the ground and fiscal tightening – to ensure that public finances again comply with the criteria of the Growth and Stability Pact – is hanging like a black cloud above the European economy. On the other hand, in this election year the US will be more inclined to implement further fiscal stimulation. The tug-of-war concerning Greece is not, in our view, so much about the maximum of 50 billion euros the country will require over the coming months, but more about the sustainability of European public finances in general. Now that Germany, for example, also wants (or has) to start tightening policy next year, the political resistance to helping the weaker euro brothers is great. This is not good for confidence in the euro, to start with, but it will also put the ECB under pressure to soften the fiscal tightening by maintaining an easy monetary policy or even easing policy. We expect the fall in EUR/USD to come to an end around 1.30 (although, if the US economy has recovered more strongly than we now foresee, the rate could slide further towards 1.25). Higher (real) interest rates and speculation on a tighter monetary and fiscal policy will then knock back stocks and growth expectations. We
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then expect the speculation on monetary tightening in the US to turn into speculation on monetary easing. By that time, concerns will also be growing with regard to US public finances, particularly at a more local level. The US is highly dependant on foreign capital. Any damage to its status as a country with big liquidity markets and After that, we expect doubts concerning the US strong creditworthiness could have negative consequences for the dollar. China, for to grow and EUR/USD to example, is increasingly questioning the reliability of the US as a solid investment, also for political reasons. rise towards 1.42 and possibly even 1.47.
We therefore envisage EUR/USD experiencing a major correction later this year (from 1.30 - 1.25) towards 1.42. Should Europe, in the meantime, arrive at a more structural solution for preventing the kind of problems arising in Greece at the moment, then EUR/USD could rise to 1.47. The more trouble the Greek problems cause the European economy and the euro, the more chance of a structural solution. The long-term trend is towards 1.20, though.
The major movement of EUR/USD in the coming quarters, however, remains a fall towards 1.20 or lower, in our view. This, as we have explained in earlier reports, is the result of the reversal of dollar-funded carry trades and more safe haven flows towards the dollar as soon as the asset markets resume the bear market that started in 2007. Moreover, in the long term we foresee the dollar benefiting from a more competitive and flexible American economy. Finally The current economy is characterised and highly dependent on the historically unprecedented scope of fiscal and monetary stimulation. This makes it far more difficult to analyse the economy and financial markets based on past knowledge and experience. Due to the strong stimulation of the Chinese economy, for example, according to an increasing number of economists, it is threatening to overheat and a (property) bubble if forming in China that could burst at any moment. If this does, indeed, happen in the near future then the scenario of stock prices and interest rates rising further is quite unrealistic and the dollar could appreciate far more quickly than we expect now. Politicians are another wild card. With the recovery only taking off slowly and unemployment mounting in many countries, civil unrest is increasing. Politicians are therefore inclined to give in to the often populist tone of domestic criticism and lose sight of the bigger picture. Our political department helps us to analyse these changes properly, but that does not alter the fact that political developments can cause many a surprise. In other words, we are fast approaching an era that has little precedent in history, which demands extra attentiveness.
EUR / USD
EUR / JPY 1.525
140.0
1.500
137.5 135.0
1.475
132.5 1.450 130.0 1.425 127.5 1.400
125.0
1.375
Sep
Nov 09
Jan
Mar
1.350
10 Source: Reuters EcoWin / ECR
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122.5 Sep
Nov 09
Jan
Mar
120.0
10 Source: Reuters EcoWin / ECR
USD / JPY 94 93 92 91 90 89 88 87 Sep
Nov 09
Jan
Mar
86
10 Source: Reuters EcoWin / ECR
Back to summary ^
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