Volatility is defined as the ’uncertainty of path’ and as such the second half of 2011 will be volatile and the uncertainty almost as great as during the financial crisis.
The 2008/09 financial crisis was an opportunity missed for the policymakers and politicians alike as only in times of distress is there consensus for change and doing the right thing. Instead politicians took the lead and kicked the can down the road by effectively piling more debt onto debt and merely transferring risk from the financial sector to the public sector under the illusion it would be easier to finance under such regime change.
Now, two years later, and almost to the day, such policy and economic errors have compounded with almost nothing to show for in terms of key parameters for long-term economic growth, like housing and employment.
Meanwhile, the social dimension has taken an even greater role, not only in the G-20 but also in MENA and Asia. Generations X and Y are clearly unhappy with the status quo and demonstrations in the centres of Madrid, Athens, Lisbon and MENA are clear signs that something needs to be done to realign implemented policies with the required need for structural change. What the world needs to move forward is an agenda on growth and jobs, not on how to buy more time.
This may be the key change looking into Q3 of 2011, as the opportunity cost of doing nothing - always the preference for elected parliamentarians - is on the verge of being far too costly.
Germany needs resolution as Chancellor Merkel fights the domestic agenda, including public reservations about the continued game of bail-outs, of sovereigns at the Eurozone periphery, but also the incoming legal challenge from a constitutional court in Karlsruhe on the issue of legality of these bail-outs. She wants to clear the problems of Greece, Portugal and potentially Spain, before Germany again goes to the polls in 2013.
I have travelled on three continents during the past quarter and it strikes me that although all three have different starting points, they ultimately face the same serious problem: the social dimension, or to put differently - the disparity between the rich and the middle/lower class - is as big as ever in the U.S., in Europe, and in Asia/China.
China has decided to change its focus in the new five-year plan starting next year, with increased attention on fighting inflation, which is another word for social tension, as the recent experiment of U.S. quantitative easing, at least for Asia, has meant spiking energy and food prices which have translated into falling disposable income. Singapore now has a policy of “inclusiveness” – securing everyone is on board the growth and income train – and we think this will be the major buzzword not only for the rest of 2011 but also in 2012/2013.
The price for this Asian focus on inflation is much lower marginal growth for the rest of the world. In slowing growth from +10 per cent to a more sustainable 4-6 percent, China will have a huge impact on global growth as it will contribute negatively to new net growth. This is a major change from the financial crisis, where China took the lead and made huge stimulus contributions, and from 2008 into 2011 stood for 50 percent of all new growth in the world.
Against this backdrop of continued weaker growth, and hence higher fiscal deficits, it is almost inevitable that policymakers will be back with some sort of stimulus.
In the U.S., present consensus is that the political hurdle rate for doing QE3 is too high but we suspect a market correction in excess of 10 percent (of which we have already seen more than 6 percent), a continued lack of traction on new jobs and the inability to restart the housing market will make for perfect pre-conditions for some sort of stimulus. We believe this will be either QE3 – or maybe more likely and more politically acceptable a revisit to the 1960s experiment of ‘Operation Twist’.
Operation Twist was a late 1950s and 1960s Federal Reserve policy of supporting the U.S. dollar and the housing market simultane-ously by outright buying of 10-year Treasury bonds while financing it by selling Treasury bills in the short-end. This forces the yield to flatten, the short-end goes up, slightly (supporting the inflation hawk credentials) and keeps the all- important 10-year yield below “market price” and if you substitute U.S. dollar support for commodity impact – you could kill two birds with one stone as higher short-term interest rates should curtail higher commodity prices via less rich financing available.
Chairman Bernanke commented on Operation Twist in his “famous” - or should it be “infamous” - speech called: “Deflation: Making sure ‘It’ does not happen here”, the very same speech which was the academic reasoning behind QE and QE2. Bernanke wrote in footnote 11:
‘An episode apparently less favourable to the view that the Fed can manipulate Treasury yields was the so-called Operation Twist of the 1960s, during which an attempt was made to raise short-term yields and lower long-term yields simultaneously by selling at the short end and buying at the long end. Academic opinion on the effectiveness of Operation Twist is divided. In any case, this episode was rather small in scale, did not involve explicit announcement of target rates, and occurred when interest rates were not close to zero’
Bernanke clearly concludes that the only reason for Operation Twist failure was inadequate size and the lack of an explicit target rate. We think Bernanke could dust Operation Twist off and go for a final all-in and declare that the 10-year yield is now 2.0-2.5 percent and the Fed will intervene to support this. This would be balance-sheet neutral, buying only exactly what they sell in T-bills, and it would be less “political” as who does not want their local housing market restarted?
In Europe we are closer to QE3 – talk centres now on how the U.K. needs to continue its QE, while in Europe there is obviously a need for something other than the European Central Bank buying peripheral bonds to support and facilitate funding. It is almost like in football: in the end Germany always wins – or rewritten for the EU: Germany needs to and can help out if needed – how it does so will decide not only the EU’s future but how in the 11th hour we can link the growing social tension (more than 40 percent youth unemployment in Spain, more than 10 percent unemployment in countries around the Mediterranean Sea) with a constructive solution.
A solution based on buying more time, which is the most likely, will only take us closer to the feared full blown Crisis 2.0. A solution needs to be forward looking and involve an agenda for dragging Europe out of the low growth stalemate which we have been in for far too long. Time is here and now, and not something you can buy.
The above macro picture leaves us with three major themes:
• The EU and US debt issue – time is up – decisions are needed
• Asia/China growth slow down as they turn to fighting inflation in earnest
• Social tension needs addressing – otherwise not only do we lose the young generation but we also fail to provide inclusiveness, the very basis for sustainable growth, peace and prosperity.
Against this backdrop we need to maintain a defensive allocation outlook. Our two main risk models, the valuation model and the tactical asset model both indicate risk-off as we look into Q3 – whether this is a mean-reversion move, where growth and solutions on the above challenges are found, or a more deep correction beyond the 10 percent correction we called for in May, is the key question.
In times of uncertainty, and certainly in times of what we call maximum uncertainty, we operate with three main scenarios:
QE /Operation Twist to Infinity – which is our high probability scenario with 45 percent odds. This is the ‘buying more time – more of the same, kicking the can down the road’ scenario. We realise and calculate that doing nothing, or more of the same, always is the policy choice of preference. But we have lowered our odds from 65 percent in Q1 and Q2 to 45 percent for Q3 and Q4 due to an upside correction to Crisis 2.0.
Crisis 2.0 is now our second most likely scenario with 30 percent probability, but one which is rising in probability (from 15 percent) due to the almost total standstill on debt in Europe and the U.S. and continued rising inflation in Asia. This is a scenario where the bill needs paying. We have a short relative deep correction, not only in the stock market but also on higher unemployment and interest rates, which create a sense of urgency, and crisis, which could be used to facilitate both the political and structural changes needed. A historical fact remains: only in the deepest times of trouble does mankind become truly rational and constructive. We think a quick crisis 2.0 could create a political environment for change, and this is an important start to one of the best periods in our history, as we, after the crisis, would have better leverage in society, more sense of urgency, agendas for balanced growth and a need to employ people. Crisis 2.0 is a bad short-term step on the way towards something good and necessary to move on from.
Finally, our last scenario is the 1970s, with odds of 15 percent. It entails big government, stagflation, high energy prices and rising interest rates. Stock markets going nowhere, not falling too much either as the micro level works it wonders on the macro level, not necessarily the worst scenario but one which will challenge the social construct.
We expect the world to extend the stimulus across the global economies as the most likely outlook for Q3, which means we will have acceptable growth but an increased burden on fiscal payments and a need for structural changes. The world is now closer to some kind of a solution. But whether voluntary or not, the solution is increasingly more volatile, so defining the theme for the coming quarter as one of Maximum Uncertainty seems quite apt.