Thursday, September 15, 2011

Are there any optimists left?

First a sorry for having been inactive over the past weeks, I just had a lot going on but I really hope to write again more frequently.

Here is a brief summary of my current thinking. In short, I am not as negative as the prevailing sentiment and recent price action implies. I rather think that over a time period of a few months we will have an improving state of affairs:
a) Recession risk in the US slowly drops. Monetary policy in the US has turned highly accommodative amid record low/negative real yields and an ongoing high level of liquidity. Fiscal policy promises to be roughly neutral to slightly positive for growth. Additionally, the drag on growth from construction activity has passed. Finally, lower inflation (amid lower commodity prices) means that households have more spending power again despite weak wage growth. Overall US growth should be around 1.5% for the next quarters.
b) Emerging markets central banks will move from policy tightening to policy easing amid lower inflation risks. Most emerging markets are in a normal business cycle. Growth was high, fuelling inflation and with that the central banks tighten monetary policy to slow growth and tame inflation. However, as commodity prices have peaked during spring and have receded since, inflation rates should start to drop significantly soon given that energy and food play a significant role in emerging markets' consumption baskets. This should improve growth prospects again and helped developed market exports.
c) Eurozone growth will be significantly weaker than has been the case over recent quarters amid recession in Italy, Spain, Portugal, Greece and very weak growth in France. Germany will continue to do relatively well (approx. 2,5% real growth). However, I do not see a wave of sovereign and/or bank defaults.
First, I expect Italy to move into a recession. Italian treend growth has been low over the past decade (only around 1%). Low trend growth combined with significant fiscal tightening, high real yields (10y BTPei real yields are trading above 4.5%) and a banking sector which amid the sharp reduciton in market value and limited access to funding markets will likely tighten credit availability for corporates and households is very likely to drive growth into negative territory. In the case of France, some fiscal tightening coupled with a high dependency on weak economies such as Italy and Spain as well as the hit to the banking sector will result in weak but positive growth. For Germany, however, I expect that exports to non-Eurozone countries will remain strong (Germany should continue to gain market share in international markets) while domestic consumption should become a growth driver again as inflation eases (thereby fuelling real wage gains) and also construction should be strong amid record low real yields. Overall, Eurozone growth should come in around 1%.
More importantly, though, I do not expect a systemic financial crisis and no wave of sovereign and/or bank defaults. First, countries such as Italy and Spain are being kept liquid by the ECB's bond buying measures while Portugal and Ireland remain liquid amid their bail-out programmes. The banks are kept liquid via the ECB as well (unlimited term funding and now also 3m USD loans) and as announced yesterday the government-guaranteed bond funding programme will most likely be prolonged. With respect to Greece, I expect that the EFSF overhaul will be ratified by the national parliaments and the Greek bond swap will go ahead (even if the participation rate is below 90%). Once that happens, the  threat of an immediate Greek default recedes significantly. One should not forget that the funding needs of Greece post the bond-swap will be very low. First, there will be almost no bond redemptions and additionally coupon payments should drop given that the interest rate Greece has to pay on the new bonds and the bail-out loans are lower than on the outstanting GGBs on average. Finally, if Greece really goes ahead with the privatisation programme, they can cover a large share of the remaining fiscal deficit/bond redemptions. Hence, the quarterly review by the Troika will lose in importance as the sums involved to be paid under the bail-out programme will drop sharply next year.

Overall, this constitutes a relatively upbeat outlook, especially in the light of the pricing action in recent weeks and should be met with higher equity markets and higher Bund yields over the longer term. Near-term, volatility promises to remain high. From a technical perspective, the German Dax has finally broken through its steep downward trendline on a closing basis yesterday (also the US Nasdaq) and starts to emit bullish signals. 10y Bund yields (and the Bund future) are trying to break a 6-weeks steep downward trend and should they close above 2% send a strong bond-bearish signal as well.