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Greed & Fear on ‘desperate reflation’
Sep 28 12:44
by Gwen Robinson
The ebullient stock-market action since the Fed easing makes it clear that, when the next bubble forms, it will be in Asia and emerging markets, says CLSA’s Christopher Wood in the latest issue of his client newsletter, Greed & Fear.
The MSCI Emerging Markets Index is back at an all-time high, as is the MSCI All Country Asia ex-
Japan Index. More importantly, perhaps, Asia and emerging markets have outperformed the S&P500 “spectacularly” since their mid-August lows, with the BRIC countries leading the way. Thus, the MSCI AC Asia ex-Japan Index and the Emerging Markets Index have rebounded by 26% and 23%, respectively, in US dollar terms since bottoming in mid-August, while the MSCI BRIC Index has risen by 33%. By contrast, the S&P500 has risen by only 8.4% over the same period.
The main conclusions, then, are clear, says Wood. First, “it makes sense to remain structurally overweight Asia and global emerging markets - most particularly for genuine long-term investors such as pension funds. For a new round of Fed easing is akin to lighting a match to the Asian asset-reflation story”.
Second, “if the US consumer does not slow in a material fashion, then world stock markets bottomed in August”.
It is the second conclusion, however, that Wood still questions. The view is that more of a growth scare is coming as a result of housing- and credit-related problems, which will hit stocks when these problems emerge. “For Wall Street-correlated stocks want to see growth, which is why they have ceased to be positively correlated to bonds ever since the subprime problem first hit the public consciousness in February”.
The “silver lining” of such a renewed growth scare is that it will precipitate more aggressive easing from the Fed and, quite likely, co-ordinated easing from other central banks worried not only about growth but also about dollar weakness, says Wood. Indeed, the dollar, he adds, “is becoming rather important”.
"Billyboy Ben’s panicky 50bp cut last week, in obvious response to jawboning from the executive branch of government, will go down in history as one of the milestones on the way to the long-since-inevitable collapse of the US dollar paper standard - a trend that has been in place ever since Richard Nixon broke the link with gold back in 1971."
If this is the big picture point, the short-term call is where the dollar will go from here. Wood is less convinced of the short-term call than of the fact that the dollar is heading for a “long-term collapse”. Right now is not the time to be dogmatic on the dollar from a technical standpoint, he adds. “For the US dollar index is now at 78.3, which is just above the level of 78.2 where the dollar last bottomed, in September 1992″.
The stakes are, therefore, high. Either the dollar is going to break down completely (which in Wood’s view has bearish implications for global stock markets in terms of the questions it raises about the Fed’s ability to maintain autonomy in setting interest-rate policy), or the US currency is going to stage a counter-trend rally off this long-term support level.
Such a rally could be driven by short covering, as well as by the forex market’s sense that other central banks are going to have to start cutting rates too in order to fend off US dollar weakness, he predicts.
The best environment for Asian stocks in the short term is for the dollar to stay weak but not
collapse through this perceived support level, which would likely trigger a new wave of chart-related
selling, says Wood. But such continuing sideways action is unlikely, in Wood’s view. More likely is that the dollar either breaks down completely or bounces sharply off long-term support.
In this respect, Greed & Fear advises investors “simply to wait and see what happens” in the current circumstances, where it is better to be guided by market action and not be dogmatic. In the meantime, Wood reminds us, the last time the dollar bottomed, back in 1992, the bottom was made because of co-ordinated central bank intervention.
This raises the question of whether world central banks will again be willing to buy dollars to allow America to “continue to play its reckless game of chicken with the world economy”.
Wood believes that reluctant, co-ordinated intervention to “save” the dollar will probably come if the dollar completely breaks down. But that stage has not yet been reached. In the meantime, the issue is whether central banks such as the ECB and Bank of England will start cutting rates.
Greed & Fear’s guess is that weaker economic data and continuing credit problems will give these central banks an excuse to start cutting rates in coming months. For now, the money markets expect the BoE and the ECB both to be cutting by 25bp in 1Q08.
What about the credit problems? Is the story over, as stock markets clearly want to believe?
This story is far from over, in Wood’s view, although it is true that Libor rates have come down significantly during the past week. The acid test, he says, “will come only when the next credit problem emerges”. Unsurprisingly, he predicts that such problems are surely inevitable, if, as is likely, “the US housing market continues to deteriorate and if US consumption continues to slow”.
In this respect, Wood notes an interesting interview on Bloomberg this week with an American small-cap investor who highlighted that domestic-orientated companies, such as restaurants and trucking firms, are seeing sales volumes decline as costs rise. Yet the Russell 2000 index is apparently trading on 39x earnings, he notes.
This should serve to remind investors that “the key development for all world stock markets in the next few months will be what happens to the US economy, not what the Fed does”.
In this respect, all the macro risk remains on the downside. The continuing strength of commodities , meanwhile, cannot be viewed solely as a confirmation of global economic strength, since commodity strength also reflects US dollar weakness - as does the resilience of the S&P500.
As for the strength of oil, the bull story remains more about rising production costs and declining cheap reserves than about a lack of supply or booming demand. Such is the argument put by Hernan Ladeuix, CLSA’s head of oil and gas research, who expects that long-term oil prices will trend at US$60/bbl in real terms, but with intermittent spikes to US$80-100/bbl in the next three to five years. Clearly, one such spike is now under way, helped by US dollar weakness.
But Wood still views oil and hard commodities in general as “tactically vulnerable to more of a US-led growth scare”. What is evident is that the growth in oil demand from the likes of China and India is not as strong as the more fervent bulls assume, he says.
All that, and the related continuing growth-scare risk, is why Wood would “rather continue to own interest-rate sensitives in Asia ex-Japan geared to domestic demand rather than commodity cyclicals”.
Indeed, he says, Greed & fear “will only aggressively add to commodity-related cyclicals in the
Asia ex-Japan thematic portfolio if and when more of a slowdown in the global economy is better discounted”.
So, if the view here is that more of a US-led slowdown is coming, that also raises the issue of how effective will be the likely co-ordinated central banking easing. “Whereas stock markets still have a touching, if not absurd, faith in central banks and their ‘bold actions’, Wood reminds investors that monetary easing is not going to be as effective reflating debt-driven growth in the west as many assume if banks’ balance sheets will be constrained, as is Greed & fear’s view, by an extended hangover from the structured-finance boom.
This is why Fed easing will ultimately go on longer than the market currently expects, he concludes. “It is also why western financials remain a structural short”. But for Asia, the more aggressive the Fed easing, the greater will be the asset-reflation bubble that will be the ultimate consequence of desperate US efforts to reflate.
On that last point, the past week has seen more definitive evidence that the US housing market
continues to deteriorate, be it rising inventories of unsold houses or accelerating house-price
declines. But for those investors who want to still short homebuilders, Wood’s advice is now to
“short British homebuilders, not American ones”.
Greed & Fear on ‘desperate reflation’
Sep 28 12:44
by Gwen Robinson
The ebullient stock-market action since the Fed easing makes it clear that, when the next bubble forms, it will be in Asia and emerging markets, says CLSA’s Christopher Wood in the latest issue of his client newsletter, Greed & Fear.
The MSCI Emerging Markets Index is back at an all-time high, as is the MSCI All Country Asia ex-
Japan Index. More importantly, perhaps, Asia and emerging markets have outperformed the S&P500 “spectacularly” since their mid-August lows, with the BRIC countries leading the way. Thus, the MSCI AC Asia ex-Japan Index and the Emerging Markets Index have rebounded by 26% and 23%, respectively, in US dollar terms since bottoming in mid-August, while the MSCI BRIC Index has risen by 33%. By contrast, the S&P500 has risen by only 8.4% over the same period.
The main conclusions, then, are clear, says Wood. First, “it makes sense to remain structurally overweight Asia and global emerging markets - most particularly for genuine long-term investors such as pension funds. For a new round of Fed easing is akin to lighting a match to the Asian asset-reflation story”.
Second, “if the US consumer does not slow in a material fashion, then world stock markets bottomed in August”.
It is the second conclusion, however, that Wood still questions. The view is that more of a growth scare is coming as a result of housing- and credit-related problems, which will hit stocks when these problems emerge. “For Wall Street-correlated stocks want to see growth, which is why they have ceased to be positively correlated to bonds ever since the subprime problem first hit the public consciousness in February”.
The “silver lining” of such a renewed growth scare is that it will precipitate more aggressive easing from the Fed and, quite likely, co-ordinated easing from other central banks worried not only about growth but also about dollar weakness, says Wood. Indeed, the dollar, he adds, “is becoming rather important”.
"Billyboy Ben’s panicky 50bp cut last week, in obvious response to jawboning from the executive branch of government, will go down in history as one of the milestones on the way to the long-since-inevitable collapse of the US dollar paper standard - a trend that has been in place ever since Richard Nixon broke the link with gold back in 1971."
If this is the big picture point, the short-term call is where the dollar will go from here. Wood is less convinced of the short-term call than of the fact that the dollar is heading for a “long-term collapse”. Right now is not the time to be dogmatic on the dollar from a technical standpoint, he adds. “For the US dollar index is now at 78.3, which is just above the level of 78.2 where the dollar last bottomed, in September 1992″.
The stakes are, therefore, high. Either the dollar is going to break down completely (which in Wood’s view has bearish implications for global stock markets in terms of the questions it raises about the Fed’s ability to maintain autonomy in setting interest-rate policy), or the US currency is going to stage a counter-trend rally off this long-term support level.
Such a rally could be driven by short covering, as well as by the forex market’s sense that other central banks are going to have to start cutting rates too in order to fend off US dollar weakness, he predicts.
The best environment for Asian stocks in the short term is for the dollar to stay weak but not
collapse through this perceived support level, which would likely trigger a new wave of chart-related
selling, says Wood. But such continuing sideways action is unlikely, in Wood’s view. More likely is that the dollar either breaks down completely or bounces sharply off long-term support.
In this respect, Greed & Fear advises investors “simply to wait and see what happens” in the current circumstances, where it is better to be guided by market action and not be dogmatic. In the meantime, Wood reminds us, the last time the dollar bottomed, back in 1992, the bottom was made because of co-ordinated central bank intervention.
This raises the question of whether world central banks will again be willing to buy dollars to allow America to “continue to play its reckless game of chicken with the world economy”.
Wood believes that reluctant, co-ordinated intervention to “save” the dollar will probably come if the dollar completely breaks down. But that stage has not yet been reached. In the meantime, the issue is whether central banks such as the ECB and Bank of England will start cutting rates.
Greed & Fear’s guess is that weaker economic data and continuing credit problems will give these central banks an excuse to start cutting rates in coming months. For now, the money markets expect the BoE and the ECB both to be cutting by 25bp in 1Q08.
What about the credit problems? Is the story over, as stock markets clearly want to believe?
This story is far from over, in Wood’s view, although it is true that Libor rates have come down significantly during the past week. The acid test, he says, “will come only when the next credit problem emerges”. Unsurprisingly, he predicts that such problems are surely inevitable, if, as is likely, “the US housing market continues to deteriorate and if US consumption continues to slow”.
In this respect, Wood notes an interesting interview on Bloomberg this week with an American small-cap investor who highlighted that domestic-orientated companies, such as restaurants and trucking firms, are seeing sales volumes decline as costs rise. Yet the Russell 2000 index is apparently trading on 39x earnings, he notes.
This should serve to remind investors that “the key development for all world stock markets in the next few months will be what happens to the US economy, not what the Fed does”.
In this respect, all the macro risk remains on the downside. The continuing strength of commodities , meanwhile, cannot be viewed solely as a confirmation of global economic strength, since commodity strength also reflects US dollar weakness - as does the resilience of the S&P500.
As for the strength of oil, the bull story remains more about rising production costs and declining cheap reserves than about a lack of supply or booming demand. Such is the argument put by Hernan Ladeuix, CLSA’s head of oil and gas research, who expects that long-term oil prices will trend at US$60/bbl in real terms, but with intermittent spikes to US$80-100/bbl in the next three to five years. Clearly, one such spike is now under way, helped by US dollar weakness.
But Wood still views oil and hard commodities in general as “tactically vulnerable to more of a US-led growth scare”. What is evident is that the growth in oil demand from the likes of China and India is not as strong as the more fervent bulls assume, he says.
All that, and the related continuing growth-scare risk, is why Wood would “rather continue to own interest-rate sensitives in Asia ex-Japan geared to domestic demand rather than commodity cyclicals”.
Indeed, he says, Greed & fear “will only aggressively add to commodity-related cyclicals in the
Asia ex-Japan thematic portfolio if and when more of a slowdown in the global economy is better discounted”.
So, if the view here is that more of a US-led slowdown is coming, that also raises the issue of how effective will be the likely co-ordinated central banking easing. “Whereas stock markets still have a touching, if not absurd, faith in central banks and their ‘bold actions’, Wood reminds investors that monetary easing is not going to be as effective reflating debt-driven growth in the west as many assume if banks’ balance sheets will be constrained, as is Greed & fear’s view, by an extended hangover from the structured-finance boom.
This is why Fed easing will ultimately go on longer than the market currently expects, he concludes. “It is also why western financials remain a structural short”. But for Asia, the more aggressive the Fed easing, the greater will be the asset-reflation bubble that will be the ultimate consequence of desperate US efforts to reflate.
On that last point, the past week has seen more definitive evidence that the US housing market
continues to deteriorate, be it rising inventories of unsold houses or accelerating house-price
declines. But for those investors who want to still short homebuilders, Wood’s advice is now to
“short British homebuilders, not American ones”.
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