Asymmetrical Risks Means We Remain Cautious For Now

Global markets continued to fall off a cliff in the past days as faith in policymakers to find definitive solutions to the debt crises and to rejuvenate global growth plummeted. The MSCI World Index has fallen by more than 20% since peaking on 2-May. And just in the past week, the index plunged by more than 7%.

In rapid succession over the past two weeks, announcements by policymakers across the Atlantic to tackle the unemployment and growth issues in the US and the sovereign debt crisis in Europe have failed miserably to inspire confidence. US President Obama’s bold US$477 billion jobs plan announced on 8-Sep and the US$3 trillion deficit reduction announcement on 19-Sep did not change the US outlook much because investors remain unconvinced that his plans will be approved by Congress given the entrenched polar positions taken by the two political camps. In Europe, leaders seem to be only paying lip service to keeping Greece in the euro-zone while refusing to consider more drastic actions to enlarge the rescue fund or the issuance of euro-bonds. In fact, the proposed changes to add more flexibility to the European Financial Stability Fund (EFSF) have yet to be ratified by the individual countries.

To make matters worse, the Federal Reserve reminded us last week of what we knew but refused to acknowledge – that the Fed has run out of good ideas to stimulate the economy. The markets have been looking up to the Fed because they are independent and not bogged down by politics, and are thus able to act decisively when needed.  Unfortunately, that bastion of hope took a beating last week when the markets promptly sold off after the Fed’s FOMC meeting. The Fed’s announcement to “twist” its balance sheet from shorter dated bonds to longer dated assets by US$400 billion was a dud. With long rates already at historic lows, another few tens of basis points lower would hardly change much of consumers or corporate behaviour. The new reality is that the Fed has no more real bullets and that “Operation Twist” is more a gesture than deliverance. That is why the markets tanked.

Clearly, the current market environment is still characterised by significant systemic and cascading economic risks. While we would like to be more constructive on the markets after such a hefty correction, we feel the balance of risks remains asymmetric at this point.

In our opinion, the sovereign debt crisis in Europe is the more immediate risk because it has the potential to roil the banking system and further threaten the already stalling global growth. There are many variables and flashpoints but a resolution to the Greek debt situation (i.e. haircut) in our opinion is a necessary first step for us to become more constructive. We would also want to see a sufficient firewall in the form of an enlarged rescue fund to prevent contagion to other European countries and the banking system. With mounting pressure from investors and from foreign counterparts, we should see a breakthrough in the coming weeks and a resolution likely before end of the year. 

  

Even if we get a resolution and an orderly one, risk assets such as equities, commodities and high-risk debt still have a long wall to climb. Risk assets thrive on economic growth and it is quite clear that growth in this “new normal” of debt reduction and fiscal austerity will be low. And there is not much more policymakers can do to stimulate growth when governments do not have much means to spend and central banks do not have much room to reduce interest rates. In other words, any market rebound subsequent to a crisis resolution may not have very strong staying power.

There are many “what ifs”. What if we do get an elegant resolution in Europe soon and there is no double dip. Or what if we are wrong and a resolution to the debt crisis is not forthcoming, or we have a resolution but a messy one. The odds seem to suggest that the balance of risks is still asymmetrical at this stage. Hence, we continue to advocate caution. The equity exposure in the “conservative” and “balanced” profiles now stands at 15% and 30% respectively.

Our strategy to go East has not yielded much as Asian markets have been held hostage to external macro events notwithstanding their better fundamentals. In fact, Asian currencies and equities suffered their biggest weekly drop in three years as capital flowed out quickly last week. The limitations in terms of breadth and depth of Asian financial markets mean these markets can react violently to swings in capital flows. Although Asian and emerging markets are still our preferred investments, without a breakthrough in the debt crisis, these assets remain extremely vulnerable to external factors.

A rebound is still possible on oversold conditions. And valuations in certain markets are looking extremely attractive. However, the sustainability of such a rebound will be suspect as long as the situation in Europe remains status quo and the global fundamentals remain weak.

For those with a stronger risk appetite and longer term view, as always, incremental buying on major pullbacks may still be a sound strategy.

Lastly, the recent correction in gold presents attractive entry points for investors looking to add on to their portfolios. We expect the rush into USD as a safe haven would unwind at some point. First, it was gold, then yen and the Swiss franc. But with the Swiss and Japanese central banks stepping in to prevent further appreciation of their respective currencies, markets turn their attention to the USD. With all the quantitative easing and money printing in the developed economies, it wouldn’t be long before the music stops and the only chair left is reserved for gold.

US Job Growth Stagnates

Zero jobs added for August! The US economy slammed into a wall in August. The non-farm payroll was the first concrete data to confirm the weak economic survey figures the past month. Political infighting over the budget and mounting fear of a default in Europe had taken a toll on consumer and business confidence prompting a severe market sell-off in August.

With jobs growth slowing, financial markets wobbling, the odds of a US recession has increased dramatically. After all, the economy only expanded at a 1% pace in the second quarter following a 0.4% gain in the first three months of the year. Consumer spending grew 0.4%, the smallest increase since the last three months of 2009.



Source: WSJ



As can be seen from the middle chart above, this is one of the weakest job recoveries in the past three decades. Given that consumption accounts for 70% of the US economy, the poor employment situation at 58.2% constrains the broader recovery.

All eyes are now on policymakers. Mr. Obama will address the nation on Thursday. He will likely focus his speech on jobs and housing. But a new stimulus is certainly out of the question after the fiasco in Congress last month just to extend the debt ceiling. Without further fiscal means, Obama should forget about grand programmes in government-led jobs creation at this stage and instead focus on government-private sector initiatives which will help small businesses access capital, grow and hire people.

That leaves the ball in the Fed’s court. At the recently concluded Fed powwow at Jackson Hole, Mr. Bernanke did not exude a sense of urgency to initiate further monetary stimulus. His reticence underscores two points in our view. First, he doesn’t want to raise too much expectations as he probably knows his tools and financial power are now limited. Second, there are tensions within the FOMC. The Fed's unprecedented decision at its August meeting to keep short-term rates at near-zero levels until 2013 led to three dissents from Fed governors.

But with zero jobs added in August, we expect the Fed will announce another round of stimulus at the September FOMC on 20-Sep, or perhaps even before. This will likely take the form of manipulating the yield curve by pushing down long-term interest rates while keeping short rates steady (aka “Operation Twist”). The Fed will engineer this by changing the composition of assets on its balance sheet rather than expanding its size as it had done in the previous two rounds of quantitative easing (QE). This involves selling off bonds of shorter maturities and switching into longer dated ones.

How does this help the economy? Apart from generating the so-called wealth effect from rising asset prices, the idea of Operation Twist is that the lower long-term interest rates would drive further business investments and housing demand.

Will it be effective? QE1 and QE2 both generated massive gains in asset markets. Not just in equities but also commodities. But sadly, it hasn’t done much for the actual real economy. The problem is not just about the level of interest rates but rather a clear lack of incentives for lenders to lend and borrowers to borrow. Banks are still nursing their balance sheets after the devastation from the 2008/9 global financial crisis and consumers lack confidence to spend because of job insecurity. Companies facing an uncertain future, protect their profits by slashing jobs and moving investments to emerging economies where there is still growth.

Still, we expect Mr. Bernanke to continue trying. Bernanke got the nickname "Helicopter Ben" from a speech in 2002, in which he proclaimed that deflation was a real worry and that if he had to, he would fly around the country dropping $100 bills from helicopters. Unfortunately, he had been dropping bills on a semi-dysfunctional Wall Street and Congress. Perhaps, that explains his reticence. In his speech at Jackson Hole, he stated that most of the tools that could be used to increase growth are “outside the province of the central bank” – in effect putting the ball back into Congress’ court.

While this policy helplessness is worrying, we believe the Fed’s coming action if implemented correctly (by explicitly targeting a long bond rate just like it does now with the Fed funds rate) should be sufficient to stabilise the fragile markets in the near term.

But until we see policy traction on the real economy, we will continue to re-allocate at the margin into Gold, Asian currencies, bonds and stocks if you have the appetite. I know I sound like a broken recorder on this strategy but like in the proverb – “in the land of the blind, the one-eyed man is king” – Asia does sound like the one-eyed man at the moment.