Gerard Minack of Morgan Stanley is one of the few investment strategists worth listening to. Today, he asks “Why So Cautious?”
That’s the question we get from investors when we reiterate our cautious strategic risk allocation. Some investors, the bullish ones, ask with incredulity. Others who share our caution are wondering whether it’s time to sell. In both cases — the two camps are split roughly 50/50 — investors want to know what’s driving our view. The reasons are straightforward: 1) We’re skeptical that US growth can accelerate, and while more optimistic than most on China, uncertainty remains high. 2) The high oil price is already a risk to growth. 3) The crisis in Europe appears far from over, with sovereign yields again moving higher. 4) Valuations are hovering near long-run averages and would move into rich territory with another 5-10% upside. All told, while we’ve been too cautious in our recommended risk allocation this year, we wouldn’t chase the rally at this point.
It’s all about growth, but the signals from the economic data are far from clear. With Europe stepping out of the macro spotlight, the focus is squarely on growth, inflation, and the monetary policy response. This is a positive development, but it has happened at a time when the economic data are particularly noisy. Global activity appears to be picking up after slowing last year, but the latest reading on aggregate PMIs ticked lower. This could just be a bump in the road, but it’s hard to know because US growth has been positively affected by a record-breaking warm winter that is messing up seasonal adjustments. China has a similar problem with the early New Years holiday distorting y-o-y comparisons and the current trend. There is enough dispersion in the data to appease both bulls and bears.
The perception of the US and China growth outlooks have reversed, and perhaps with it the EM over DM trade. In relatively short order, optimism has increased for the US economy, particularly around structural trends, while talk of a hard landing in China has resurfaced. Our economists have a different take on both fronts; Vincent Reinhart continues to expect a long, slow recovery for the US, while Helen Qiao expects growth in China to pick up in 2Q12 on the back of policy easing. Of the two, China is the wildcard because the extent of any weakness is far from transparent, and the scope and scale for policy stimulus is constrained relative to 2009. If China continues to slow, the fall-out for the rest of EM would make the tactical outlook for EM assets much less appealing. But China bouncing back strongly is the biggest upside risk.
Minack on the US:
Most of the optimism about the US economy seems to be due to three factors: 1) improvement in the labor market, 2) a belief that the housing market has bottomed, and 3) the potential for a positive supply side shock due to falling natural gas prices and increased oil production in the US. While there is reason to be hopeful on each of these fronts, some of the optimism is getting ahead of itself, in our view.
• Labor market: The employment picture is improving, and one of the positive secular developments is that manufacturing job growth is as fast as non-manufacturing for the first time in two decades. This speaks to the early stages of the reindustrialization of America. But in the near term, the recent pace of growth may not be maintained if warm weather pulled forward job creation. In addition, productivity is falling and unit labor costs are rising, which could deter continued increases in hiring.
• Housing market: Increases in housing starts and new homes sales suggest a housing market that has hit bottom and is starting to recover. However, there is a big pipeline of likely foreclosures — our strategists estimate 3 to 4 million by the end of 2013 — that will continue to put downward pressure on home prices. After rising last year, the Case- Shiller home price index has resumed falling over the past six months.
• Energy: The fall in natural gas prices due to the increase in domestic production could provide US businesses with a competitive advantage in the form of a cheap energy supply. However, this is more likely a 5-year effect rather than having a significant supply side benefit in the next six months.
Minack on China:
A string of disappointing economic data and a seemingly tepid policy response thus far have made China the wildcard in the global growth story. The lunar New Year holiday makes it difficult to discern just how significant the slowdown is, but the overall news flow is one of mixed signals:
• The trade balance was negative in February, as exports grew less than expected and imports more. A decline is typical around the New Year. However, the magnitude is far greater this year than in the past.
• Reports suggested the world’s biggest mining companies were warning about slowing China demand. However, what they actually said was that while construction is likely to continue to slow in 1H12, it should pick up in 2H12 and the long-term structural drivers of industrialization and urbanization remain. Growth rates are likely to flatten compared to the past 10 years, but not shrink.
• Inflation fell to 3.2% in February, providing room for policymakers to ease. However, China partially offset this positive news by raising gasoline and diesel prices; consumers will pay 0.44 CNY more per liter for gasoline and 0.51 CNY more for diesel.
• The removal of Bo Xilai, the party secretary of Chongqing, highlights the political risks in China in the year of leadership transition. It is difficult to assess how much political risk is weighing on China’s growth, but FDI had a surprising decline of 0.9% in February, while capital flight has accelerated.
• The revision of the long-term growth forecasts to 7.5% from 8% added to the concern that China is slowing. However, past forecasts have been routinely exceeded, and it’s inevitable and not unexpected that China’s growth rate would slow as the economy grew and matured.
Minack on Europe:
The LTRO and Greece bailout brought a reprieve to the crisis, but also a worrying sense of complacency. That describes many investors, but more troubling is that EU policymakers also seem to believe that the worst is over.
Unfortunately, progress on fiscal integration and growth-enhancing structural reforms — both necessary steps in a long-term solution to the crisis — are hard to achieve during victory laps. While that’s happening, and with 2Q12 risk events such as elections in France and Greece coming up, the price action in sovereign debt is flashing an amber warning. After agreement on the Greece bailout was reached, Portugal’s CDS spreads actually widened, the yield curves of Italy and Belgium have been flattening, an indication of rising concern, and Greece is already trading with an additional restructuring embedded. When this price action could evolve into something more serious is uncertain. But with growth in the periphery deteriorating because of austerity measures, the debt sustainability projections look too optimistic. If that means more debt restructurings are likely, the market will start to price in this reality sooner rather than later.
The ECB may have won the battle, but lost the war. By refusing to take a loss on its Greek debt holdings, the ECB effectively made all of its sovereign debt holdings senior to those of private investors, despite the fact that it too bought the debt in the secondary market. With this as a precedent, future purchases of Portugal, Italy or Spain sovereign debt through any QE efforts, or the SMP program, will de facto subordinate the private investors of that debt. In fact, the more the ECB buys, the bigger the potential loss to private creditors in the event of a debt restructuring. That leads to the ultimate irony: the more the ECB tries to stabilize, the more it can be self-defeating.