Bob’s World Life can be frustrating. After all, I AM a Liverpool FC supporter, a club which has to rank as one of the most frustrating teams EVER to support. But rather than getting riled by Rafa, my frustrations are instead being primarily driven NOT by the illness affecting the global economy and financial system, but rather by all the noise that is accompanying this illness. Upfront, I will say that the Credit Crunch (or whatever 'this' is called these days...it's certainly no longer 'just' a Subprime crisis!) WAS 'forecastable'. Anyone who disagrees needs to dis-own the utter claptrap that was the Greenspan (remember him!!!! & yes, he WAS knighted by our Queen) Fed's approach to bubbles (ignore them, just fix them when they burst with MORE easy money and even MORE leverage), and they need to get real. Of course NOBODY could have predicted EXACTLY how the bursting of the debt bubble would play out. But to deny there was a unprecedented debt bubble back in 2006/2007 when the evidence was clear and when quite a few of us were trying to provide as many warnings as we could must (I think) have required a thought process which is - even now beyond me. So I am frustrated that not many folks listened and acted upon these warnings going back at least 2yrs. Actually, some even took the opposite view. Hmmmm. But I am now equally frustrated that - if I go by what's in the media (financial and mainstream) - the whole world is now full of so called experts who 'called' the crisis. Funny, as when I think back to late 2006 and early 2007, when the sub-prime market had already cracked, those prepared to listen to me were few and far between. But now EVERYONE called it! Actually, scrap 'Funny' as I am almost inclined to cry instead. But what is really frustrating is that these same 'experts' either keep calling the bottom, keep telling me that policy initiative X/Y/Z will fix the ills, and even more so, these same 'experts' are I fear providing the bulk of the advise to policymakers who are trying to get us out of the crisis. Forgive me, but I cannot see how talking advice from folks who couldn't see this crisis coming even when the tsunami was starring them in the face can be of any real benefit. Perhaps policymakers should take a chance and talk to some of the folks who actually saw this coming, who understand why this crisis developed, and who have been warning of the consequences of the bursting of the bubble. You never know, maybe such folks might have an idea as to how to move forward....Thankfully at least some national policy makers ARE now listening to such people... I could rant on (I HAD a whole paragraph on the current zeitgeist of banker bashing...) but I'll stop now, as I am sure I would eventually end up upsetting someone. Lets move on to what I think right now: 1 - Trying to fix a debt crisis by encouraging EVEN MORE BORROWING is not, to me, a smart plan. Most recently this is what Bush and Greenspan engineered post 2001/2002, where they 'forced' indebtedness (away from the corporate sector and) onto the consumer sector. Yes, it may have created the illusion of wealth and good times from early 2003 to (say) early 2007, but I trust you all now accept this was merely an illusion. A combo of gross negligence w.r.t monetary policy and 'not quite the truth' w.r.t. measuring REAL inflation (I have said for YEARS that the way the US in particular measures GDP and CPI was giving us the wrong read) together gave us the illusion of wealth. Hiding disclosure on M3 was for me the very early warning sign. Ignoring asset price inflation when measuring 'official' inflation was the ONGOING warning sign. The debt crisis we are in now is - in large part - a product of these ills. So to think we can borrow and spend our way out now/again is I think quite wrong. 2 - The Obama fiscal package is NOT a solution. It is heavy on headline, but the real detail is much less impressive. What I find weird is that others don't see this. The Obama package is merely meant to MITIGATE the worst impacts of a deep and prolonged recession. It is NOT the solution. Look at the package net of the collapse in state level spending. Look at the way the planned spending is spread out over yrs. And ask yourself this - will YOU save or spend the tax cuts? To me, the answer is an OBVIOUS one - to save. Finally, ask yourselves this: You think Obama wants 1 term or 2? If he wants 2 terms, do you think he is best served by trying to spend his way out of trouble NOW and risk facing a serious inflation problem in 2011/2012, or is he best served by really opening up the spending taps in 2010/2011, ahead of the next election, when any inflation risk is pushed back into his possible 2nd term? I think this is a no-brainer. Just consider Volcker - Reagan back in the early 80s. History is a good guide I think....
3 - More broadly, has YOUR propensity to borrow and spend gone up? Or has YOUR propensity to Save and Save gone up? The Baby Boomer generations have seen their asset wealth and risk asset based savings collapse as they head into retirement. I think the critical issue here is that Savings Rates (in the West) are going to climb and climb for many years. This is good - but the transitional part of this journey is painful. As such, even if Borrow and Spend is what our leaders decide is the way out, then we need to consider how many folks and what sort of folks will lever up at a time of falling asset prices and rising unemployment. Hmmmmm. 4 - I think we are at a point where investment banking operations around the world are 'clean-ish'. But we are also now approaching a point where some policy makers - notably in the UK & US - are beginning to understand that this is NOT just a CDO/investment banking problem, but that actually core lending books of traditional banking operations are at risk. The potential scale of such 'losses' or potential losses are I think a leap forward from the bulk of the losses to date. Maybe this is why the Geithner speech from a few weeks ago was so 'vague' - after all, maybe Geithner too understands this, and maybe he has no desire to communicate this to the world just yet, for fear of sparking another meltdown in markets. For my part, I think the realisation of the scale of these embedded losses/potential losses is GOING to happen later this year, and WILL lead to the next significant leg lower in equities, wider in credit spreads, and lower in govvie bond yields as re-inflationnary policies are seen as failing/not working quickly enuff. 5 - Many millions of folks are deluded into thinking that this is just a US and UK banking sector problem. No Way. Europe is in at least a big a mess as the UK/US – there is simply a lag. This applies to the banking losses/problems, the real economy, to ECB rate cuts, to the EURO (soon) taking up the UGLIEST CURRENCY baton from GBP, which in turn took the baton from the USD. And the sector which I think will suffer the MOST is that which the perma-bulls still think will deliver us from evil. Namely, the Emerging Markets. In fact, once this is all over and we reminisce, I fully agree with my Chief Economist, Kevin Gaynor, who has said for a year that EM and Euro risk assets will suffer – relatively – the highest losses vs UK/US. 6 - This year we will see NEGATIVE real AND nominal G7 GDP - this is TERRIBLE for jobs, profits and defaults - the 1st time ever. I am fearing G7 real GDP at -4% or so this yr. And abt zero grwth over 2010. We will also see again for the 1st time ever - NEGATIVE Global grwth, with CHINA a major problem, not a major support. Folks looking to China as a solution don't get it. Sure, the Shanghai Comp is up some 25% this year. But really, am I REALLY meant to forget that this index is, even now, DOWN OVER 60% from its highs!!!!! 6 - What the mrkt I think doesn’t yet accept is that (in the West) DEFLATION is thrashing the pants off of inflation, and the mrkt stubbornly hangs onto the view that US/UK policymakers can create inflation (and thus NOMINAL grwth). I think that eventually – if one debases ones currency enuff and if one is prepared to stick 2 fingers up to the world and suffer the consequences – then this is indeed true. But I think policy makers are having/fear having their bluff’s called and as a result being exposed as butt-naked. So in other words, policymakers will tread very carefully on this point. YES, they may be successful in scaring some of us into believing that the HELICOPTERS not only are ready, but that they also WILL work. But in reality, they worry so much abt letting an uncontrollable inflation monster free, or at least sparking off a global game of currency debasement, that actually I think that for now, and for several more quarters (until it is REALLY REALLY BAD), policymakers shud be more feared for their BARK rather than their BITE. 7 - All of which to me means that this is all gonna get worse before we get the next quantum leap forward in both full disclosure AND policymaker intervention, and before it gets better. And the REAL HEALER will be TIME and falling ASSET PRICES, combined with rather than because of any policy magic. In other words, rising defaults and powerful deflation will trump all/any (nominal) +ve’s for much/most/all of this year. 8 - The other big part of the inflation deflation debate is this: The EM world is STILL much more prone to inflationary busts than the G7. It will be wise to understand that inflation for some DOES NOT mean inflation for all - there are AT LEAST some decent lags. What does this all mean for investors. Simple I think, at least on a top down year ahead asset allocation. I like G7 govvies - esp. Euro govvies (no, I do NOT think that the EMU project breaks-up this yr/next). I think at some point
later/late this yr 10yr yields on Gilts, USTs and Bunds will be at/below 2%. Talk to David Ader and his crew for their thgts. Personally, at a top down level, I do not like global equities. I can see some reason - purely driven around the relatively different likely inflation/deflation outcomes - to like EM equities relative to G7 equities, and to like some sectors over others (Ian Richards is our expert), but I still think that on an absolute basis global stock markets will all be 30/40% lower later this year. Think 550 on the S&P500 and Shanghai back at sub-1500. I do think EM Fx is a major sell vs G7 Fx. In G7, take USDs and GBPs over EUROs - Dave Simmonds, Alan Ruskin and teams can fill you in in full. The obvious ‘likes’ are JPY and CHF but currency intervention will be seen to weaken these too vs USDs. I really like Gold and Crude on a multi-yr basis. In the next 2/3 yrs gold could easily hit $2000 and Crude can easily revisit the highs of last yr and higher. These assets are the natural hedge against EVENTUAL policymaker ‘success’ and are a great hedge against rampant EM currency devals and EM inflation. Remember - the West gave up the right to make much of anything, most of all commodities - to the EM world, as a result of which THEIR inflation will eventually become OUR problem. In credit, be careful. The default cycle is just beginning and will be UGLY in the HY - HY11 at 60 later this yr, iTraxx XO at 1500+ later this yr - and EM spectrums. This cycle will play out over the next 18/24 mths and there are NO PRIZES for being early. And DO NOT get too sucked into the next ugly bubble – the one that says ‘IG corporate credit is a no-brainer BUY’. On a PA basis, I see some merit in buying and holding the best debt of the best companies. But this is very selective and ONLY on a PA basis. Would I tell my traders to load up on IG secondary cash risk – even in the best companies? Not a Chance! Ask yourself this - how would the IG corporate credit market fare if it knew that peak defaults are not only a year away but that the then default rate will far exceed anything we have seen for 30+ yrs?? And how would the IG corporate credit market fare if it knew that well over 50% of such issuers will see multiple ratings downgrades over the next 24mths??? And then ask yourself how the IG corporate credit mrkt would fare if you knew that some major benchmark AAA/AA issuers are seriously at risk of multiple downgrades?? I see the IG11 index at/above 250 later this yr, with iTraxx Main at 200+ and iTraxx HiVol at 600. In the very short term (next month) risk assets should do OK/go sideways, pretty much as they have since November. The last 3/4 mths did not feel too bullish for risk assets, but actually it was an OK period with VOLA falling and some IG spreads in particular better. I think that after last week's price action the chances are the next 2/4wks may be OK too. However this is a low conviction call and one into which I would be selling risk. The high conviction call remains for significant bear market in risk assets over Q2, Q3 and into Q4. It is difficult for us to comprehend that TIME and FALLING ASSET PRICES rather than POLICY will solve the current mess - governments can only mitigate the worst, and here the UK and US seem well ahead of the curve, if only thru necessity. The sooner we accept this, the sooner the turnaround can begin. I think that we are no more than a few months from the mrkt coming to this conclusion, and when it does the resulting asset sell-off and vola spike will mean that you will be very very happy to be long Cash, long G7 govvies, and out of EM, Equities, and most of the credit markets. The time to pick value in risk assets, and the time to run like USAIN from G7 govvies, is I think later late 09/1st half 2010. This WILL bottom out and then improve, gradually and eventually - late 09/early 2010 is my best current guess. Until then, Be Safe, Be a Survivor, and Be Liquid.
Chief Credit Strategist RBS Global Banking & Markets 135 Bishopsgate, London, EC2M 3UR Office: +44 20 7085 3249