Article / 13 August 2013 at 14:27 GMT

Insights Q3 Outlook: Waiting for reality to hit

Chief Economist & CIO / Saxo Bank

The stock market continued to rally in the second quarter and early into the third, going full steam ahead and defying the law of gravity and investment sanity. But will we see anything new for the rest of the third quarter? Or is waiting for a return to reality and normalisation, similar to Samuel Beckett’s characters Vladimir and Estragon, just like waiting in vain for Godot? 

In today’s world, the “Godot” we are waiting for is the wakeup call – the reforms needed to get the world economy back to normal, where the fuel for robust markets is not easy money, zero interest rates and negative real rates, but rather, innovation, real risk-taking and, equally important, real loss-taking. This is something we have not seen in earnest since before Alan Greenspan, the previous US Federal Reserve chairman. The high-probability scenario from here is one in which we hit new highs in the third quarter for stock markets – in the order of 1,750 or even 1,800 for the US S&P 500 Index. This is based on the tailwinds of managed earnings and a US Fed that is reluctant to end the easy money despite the obvious need to do so. Ironically, continued sluggish growth figures out of the US and core Europe, while not perfect conditions for the economy, seem to be ideal for the ongoing equity market rally because this keeps the wake-up call on hold.

But make no mistake: What I have called the “Bermuda Triangle” of economics (low growth, high stock markets and high unemployment) is not a sustainable reality. It’s an illusion and one that will become increasingly painful to extricate ourselves from the longer we continue to believe that it is real. The market backdrop in Q3 has nothing to do with economic fundamentals, but has much to do with whether politicians will continue to be able to buy time like they’ve been doing since 2008. Their loyal brothers in arms since 2008 have been the central banks, even if this year has seen the first rumblings – mostly from the US Fed, if somewhat fitfully – that quantitative easing (QE) cannot last forever and a normalisation will eventually be necessary. Indeed, the Bank for International Settlements, which some might call the central bank of central banks, even recently warned in no diplomatic terms that the concept of “as much as it takes” monetary policy had its limits and actually, if performed continuously, would hurt the ability and incentive structure of reforms.

In other words, the risk is that central banks increasingly find their own actions questionable and that, in itself, should be a dire warning for investors as they have been the main driver taking asset markets to such heights by aggressively mispricing the price of money and, therefore, the price of risk since the global financial crisis struck.

The combination of disbelief that the party will ever end and ongoing sluggish economic conditions suggests a belief that the central banks will not alter the status quo. But the issue remains that the Fed continues to talk up a tapering of its asset purchases as it can’t maintain emergency conditions forever. The timing of a withdrawal of liquidity, given the economic backdrop, does, however, look awkward.

US growth projection for the first half of 2013 is par for the course at 1.7 percent. Our forward-looking indicators don’t see any improvement or worsening, so we expect 2 percent growth for the full year after 2.2 percent in 2012. The slowdown this year is a product of tax-code adjustments and fiscal spending cuts at the margin, as well as a world economy on the ropes and a weaker US consumer (or, rather, one with less disposable income to spend).

The third quarter could be where even the slowest of investors get hooked on the stock market and its ability to climb the wall of worry, even if the driver is a tailwind of central bank puts and a supporting cast of politicians only too willing to delay any real reform. And why should politicians talk real reform when a wake-up call means short-term pain, which translates into guaranteed defeat at the next election. This inability to reconcile what’s needed (reform) with what is actually being done (buying time) is now in its final phase. This is the blow-off phase in which the remaining pockets of market participants who actually behave according to fundamentals give up, while central bankers and politicians begin to feel confident that their inaction might just work, even as the real economy refuses to reignite.

We believe Q3 could actually be a major pivot point. It could be the beginning of the end of excessively easy money and a turning point towards the slow withdrawal of QE (after a false start of the same in Q2), as well as the end of the belief that real growth can return without reforms. Ironically, even as QE is slowed, it could also be the starting point towards an all-time low in interest rates in 2014, when the final bill comes due. In other words, we do not see a bubble yet in fixed income, but still see high probabilities of new lows in yields in 2014. We can’t expect a recovery as long as small- and medium- sized enterprises (SMEs) – 80 percent of the economy – are struggling to innovate and create new jobs. Therein lies the problem: The 20 percent of the economy made up of the exchange-listed companies and quasi state-owned banks are not the innovators or job creators. They do not need to be. They buy their competitors and the strong up-and-comers. You only have to look at the tech sector, in which brand names such as Google, Yahoo and Microsoft continue to pay a massive premium for “the next big thing”.

The key event, the one we have waited for all year, is the German election on September 22, not so much because we are unsure of the outcome as it’s Chancellor Angela Merkel’s election to lose (which she won’t). Rather, this election is about how the new German government and parliament shape Germany’s EU policy. Europe remains “overbanked” with undercapitalised banks, an issue that ultimately needs to be resolved on an EU level before we will see credit flowing again in Europe. Keeping inefficient banks alive via European Central Bank life support is not helping the SMEs, or, in other words, 80 percent of the economy that really could benefit from easier credit.

We are preparing ourselves for a significant slowdown in the EU in the fourth quarter, which is now back-loaded with events that will be difficult to keep under control: Greece’s non-compliance with Troika demands; Portugal’s political instability combined with its deteriorating fundamentals; the restrictive recession in Ireland and both Italy and France giving lip service to real reforms rather than taking the medicine that needs taking. And then there’s the political scandal in Spain that has reached all the way to the top of the current government. Europe will have to stop pretending very soon.

Again, Q3 looks to be good for assets, but also the end of the extend-and-pretend mentality. The next peak in economic cycles and assets will come in 2017, so enjoy it while it lasts.


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