But both sources of liquidity supply will shortly become more restrictive. The US Federal Reserve is scheduled to wind down its extraordinary measures in coming months. Meanwhile, the Chinese central bank has already taken the first small steps along the road of tightening monetary conditions: providing “window guidance” to banks on loan growth; encouraging banks to raise more capital; and raising bill yields. But the year-ago stimulus package of 13% of GDP triggered such a rapid recovery that China’s output gap has turned positive and, as a result, inflation is picking up. More decisive monetary tightening looks inevitable – and soon.
As 2010 gets underway, global investors are showing few signs of being concerned about a deteriorating liquidity backdrop. In fact, one survey of US investors showed the smallest percentage of “bears” since 1987. In many respects, the market backdrop is a mirror image of this time a year ago. Then, sentiment was extremely bearish, liquidity conditions were becoming more favourable and business cycle leading indicators were beginning to turn up. These factors contributed to our call on 11 March to overweight equities versus government bonds. Now sentiment is extremely bullish, liquidity conditions are becoming less favourable and momentum in our global leading indicator has turned down for two straight months. The latter is consistent with a fading of the inventory-led rebound in global economic activity as excessive debt levels re-assert their drag on final demand in the “Anglo-sphere” economies.
There is one crucial difference with a year ago. By the end of February 2009, equity markets were at extremely cheap valuations on several metrics. Today, although valuations have recovered, equities are still far short of overvalued levels – no higher than neutral overall. So any setback in developed market equities, triggered by deteriorating liquidity or earnings momentum, should be a 10%-20% affair, in contrast to the collapse seen in the 18 months to March 2009. Hard commodities, whose high prices are heavily predicated on China’s growth and easy money, are the most vulnerable risk-asset category.
The US equity market may prove to be the most resilient in this scenario due to the sector composition of the market (a lower weight in expensive cyclical sectors than other regions) and a competitive dollar (US data shows evidence of world trade share gains and import substitution). At the global sector level, technology is our favourite ”cyclical” due to its modest valuations and long experience in functioning in a deflationary environment while healthcare looks attractive as a cheap defensive sector. In the US healthcare’s de-rating as a ”growth” sector has been completed since its one year forward P/E is now the lowest among the 10 sectors. This seems to already discount uncertainty over US healthcare policy and pharmaceutical patent expirations.
The imminent ending of QE contributed to an upward spike in US Treasury bond yields in December, the opposite of the effect when QE was announced a year ago. But underlying fundamentals, namely significant negative output gaps resulting in downward pressure on core inflation, are positive for most government bonds. “Safe havens,” such as US Treasuries and German bunds, may further benefit as global risk aversion increases. Japanese government bonds yielding just 1.35% (10 year) may not look particularly attractive to foreign investors but offer a good “real” yield for local investors faced with persistent deflation. Also, despite the debt/GDP ratio nearing 200%, Japan does not look hugely exposed in terms of rollover risk on government debt, primarily because about 95% of the outstanding debt is in the hands of domestic investors.
Perceptions of sovereign credit risk are likely to play a larger role outside the G3. For instance, we are cautious on UK gilts given extremely large issuance and concerns about the sustainability of public finances. The UK’s general government deficit in 2009 is estimated to be around the same level as Greece and Ireland (12% of GDP). At least those latter two are sharply cutting structural deficits in 2010, unlike the UK. The UK may have some “grace” time to address the issue as end-2008 net government debt was 34% of GDP versus Greece’s 73%. But gilts look vulnerable to concerns about further delay post-General Election (say in the event of a hung parliament).
Just as it was consensus to like corporate bonds a year ago, it now seems very fashionable to be cautious on them. US investment grade corporate bond yields are low in an historical context but we think they should still provide positive returns in 2010 as spreads to government bond yields have further room to narrow. Non-financial corporate sector free cash-flow is at record levels (as a percent of GDP),corporate debt growth has evaporated while government debt growth has soared.
Financial asset volatility is likely to end the year higher than at the start, which could undermine some hedge fund styles. Global macro should outperform, based on past relationships with volatility trends.
In foreign exchange the main valuation anomalies are the dearness of the euro (and some currencies in Eastern Europe) and the cheapness of Emerging Asian currencies. Structural weaknesses on the periphery of the Euro area seem to have finally triggered some weakness in the euro over recent weeks but this process has further to run in 2010. While we look for a stronger US dollar versus the euro in 2010, some Asian currencies can appreciate against the US dollar, probably including the Chinese yuan as the authorities there seek to tighten policy. The Japanese yen is an exception to this Asian trend. It was supported in 2009 by several factors, including a recovering trade balance and convergence in G5 short rates. However, Japan now seems to be the only major economy where further anti-deflationary measures are currently assuming greater urgency in the minds of central bankers, leaving the yen vulnerable.
