A View from the Trenches, September 22nd, 2009: "Turning neutral on equities"
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The week started with the Japanese markets closed, and I have the
sense there is a bit of anxiousness out there. There are multiple
issues shaping the outlook on capital markets, which may be an
indication that it will be difficult for the equity market to keep
rallying from here. Thus, friends, for the record, on September 22nd 2009, “A View from the Trenches” turns neutral on equities.
Do I mean the S&P500 will fall? Do I mean that the S&P500 cannot keep rallying? Not necessarily. Let’s see…
I do not think that the S&P500 will
sell-off because the market will grow impatient on macro stats, or
lower-than-expected revenue or earnings or even increased probabilities
of default. No! I do not share the rationale of the bears. As we have
been writing lately, I believe Central Banks still have a lot of
firepower in their hands to stop a run for cover. My fear is that
precisely the same Central Banks may screw up with the unwinding of
their existing liquidity programs. In fact, no matter how softly they
unwind them, the impact on relative prices in the foreign exchange,
rates and credit markets will affect equities. On political grounds,
then, the S&P500 can sell off. This differentiates my scenario from that of the bearish voices on the street.
For the same reason, I do not think equities can keep rallying on
fundamentals alone. (For the sake of honesty, I note that some months
ago, I held the same view on the potential for equities to shoot
higher. I was wrong then, because the self-feeding mechanism of lower
spreads, more refinancings and lower jump-to-default risk was a
virtuous spiral that got us where we are now. I underestimated the
secondary effects of liquidity!) However, maybe I am right this time.
My view is that the equity market would need some policy measure that
would bring clarity, confidence to the picture. So far, I cannot think
of any.
Therefore, two main 2009 themes that we have extensively discussed here come to mind:
1. - We are in the middle of an inflationary process and inflation
never brings growth. As we wrote countless times, the stagnation is
caused by the uncertainty in relative prices. Inflation is non-neutral,
affecting certain prices first, and other prices later and in the end,
when everybody realizes it is there to stay, inflation is evident
through CPI readings. For those who still believe in the CPI mystique,
I offer this comparison: As much as you cannot claim that a baby is not
alive yet when you see a mother pregnant, you cannot claim inflation
has not arrived yet because consumer prices and wages have not
increased. Trillions of debt have been monetized, lifting the equity,
credit and fixed income markets. The pregnancy started months ago and
we are going to have that baby! In the meantime, the changes in
relative prices and outlooks are still significant.
2. - All shocks have been exogenous so far, driven by politics. Therefore, we must pay attention to all things political.
The details on an exit strategy from Central Banks are still unclear.
Yes, it’s almost October and nobody really knows what the next steps
are going to be. However, while equities stagnate (hence we are
neutral), in the interest rates and credit markets, the situation is
different. Speculation is rampant on the impact of the run-off of the
Supplementary Financing Program, the end of the Mortgage Purchase
Program (expected to be extended) and the Treasuries Purchase Program
on curves, liquidity, and spreads. Perhaps the liquidity aspect of
these changes is the most critical. I will not describe it here,
because it is all rumors so far, but promise to elaborate on it once we
have more details. In the meantime, the bottom line is that liquidity
will be negatively affected and some kind of panic may arise, which
will (if it is not already doing so) negatively touch equities and
commodities, strengthening the USD.
In Credit we had the launch of Series 13 yesterday, in the CDX North
American indices. I will have more to say about the macroeconomic
implications of the current levels (CDX IG13 closed at 91/92, IG12 at
98.75/99.75) and above all, curves in the credit space. But we can
safely say that increasing fiscal deficits worldwide and a steep credit
curve with 50%+ of issuances maturing within a couple of years is close
to what Paul Krugman warned us about: The postponement of the end of
the world.
Yesterday, we wrote about the recent USD denominated sovereign
issuances in developed markets. We did further research and came across
a September 18th note on the subject by Bank of America’s Rates team.
It appears that approximately $13.6BN has been issued by European
governments in September alone. I asked an informed analyst whether
these issuances have actually been hedged against currency risk, but I
was not given a clear answer back. However, my understanding is that
the interest rate risk would not be eliminated. As we wrote yesterday,
one wonders if giving up seigniorage in exchange of a few bps upfront
is a sound policy. How big is $13.6BN? Not that much, if we think about
them as a single event in time. However, if the trend picks up, it will
be significant.
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