Yesterday we disclosed the latest thoughts from Goldman's traditionally cheerful Jim O'Neill, indicating that the strategist was shifting to a notably bearish exposure. The most notable sell-side development over the past 24 hours is that Morgan Stanley's head of European Strategy, Teun Draaisma, has now joined the bearish team, with his January 25 report titled 'Sell into strength as the tightening phase has started' - the title is pretty self-explanatory.
Summarizing Teun's concerns:
Sell into strength, as authorities have switched from 'all out stimulus' to 'let's start some stimulus withdrawal'. Tightening measures are coming in thick and fast around the world. We always thought that the start of tightening was not the first Fed rate hike, but could be many other things including higher taxes, less spending, more regulation, Chinese/Asian tightening, or Fed language change. Recent initiatives include Obama's banking initiatives, and several Asian tightening measures. In the next few months this theme is set to intensify, and we expect positive payrolls, a Fed language change, and the start of QE withdrawal. This willingness of authorities to move away from crisis mode is an important change and means that the tightening phase in the broad sense of the word has now started. Thus, indeed, 2010 is shaping up to be like 1994 and 2004, as we expected. The start of tightening is hardly ever the end of the growth cycle, and normally the accompanying dip needs to be bought, but it typically is a serious double-digit dip lasting 2 quarters or more. The sector rotation has of course already started in October-2009 and is set to continue. As a result we move 2% from equities to bonds in our asset allocation, going to +5% cash, -2% UW equities, -3% UW bonds. We think short-term strength is quite possible, and we have not quite gotten an outright sell signal on our MTIs either, but the 6 month risk-reward of being long is worsening, and we recommend to sell into strength. Our 12 month MSCI Europe target of 1030 implies 6% downside.
Zero Hedge is hardly as sanguine about economic propsects to believe that the Fed is indeed willing to tighten any time soon - in fact our belief for a while has been that Q.E. will likely be extended in some official form, which is the antithesis of tightening. However, assuming tightening is indeed on Bernanke's agenda, and further pursuing Teun's idea, yields the following interesting observations on the correlation between rates and markets- in short, the upside/downside risk, as determined by the liquidity pump, at this point has shifted materially into bears' territory.
Further quantifying the various tiers of future market performance, Draaisma presents the following three scenarios:
- Bull Case 'Goldilocks': MSCI Europe 1,400 (27%) upside - Bond yields of 3.75%, short rates at 1.25%, CPI remains low at 1.5% and EPS growth is 50%. Using a CVI value of 0, this implies a MSCI Europe target of 1400, and an implied PE of 15.
- Base Case 'Strong Growth, Rising Rates': MSCI Europe 1,030 (6% downside) - Bond yields of 4.5%, short rates at 2%, CPI is well behaved at 1.8%, and EPS growth is 35%. Using a CVI value of -0.5, this implies a MSCI Europe target of 1030 and an implied PE of 12.5.
- Bear Case 'Inflation, FX and Bond Trouble': MSCI Europe 750 (32% downside) - Bond yields reach 5%, and 3M rates as well as headline CPI to reach 2.5%. EPS growth is less than expected at 20% as input costs bite. Using a CVI value of -1, this implies a MSCI Europe target of 750 and an implied PE of 10.
And as the core variable behind Draaisma's projections is interest rates, the strategist provides the following observations on embedded risks.
Two risks to betting on repeat of bullish historical pattern.
While the past does not repeat itself, we think it rhymes, and our analysis of the past paints a positive outlook for equities and cyclicals if real rates were to rise appreciably. However, we see two risks and would caution betting on such bullish outcomes:
Risk #1 – correction associated with ‘start of tightening’. We continue to believe strong growth will lead to the start of tightening, which is tactically bearish for equities. We found that there always is some sort of equity correction around the first Fed hike coming out of a US recession – averaging 13% over 6 months, typically starting just before the first hike. To be sure, we always thought the start of tightening could be many things other than the first Fed hike in this cycle. Start of tightening in Asia, more onerous financial regulations and the general willingness of authorities to move away from crisis mode in recent weeks all means that the tightening phase, in a broad sense, has started, we believe.
In the next few months, we expect positive payroll, a change in Fed language, and the withdrawal of excess liquidity as the tightening phase intensifies. We see 6% downside to MSCI Europe in the next 12 months and recommend selling into strength (see 'Sell into Strength as the tightening phase has started', 25 January 2010).
We also found that rising real yields are not always bullish. For instance, real yields bottomed in Sept 1993 after the early 90s recession, rising from 2.0% to 5.3% by end-1994, reflecting the economic recovery. Equities reacted positively to the initial move up in real yield until the start of the Fed tightening cycle, and higher rates started to bite early in 1994. Equities then corrected 17% between February 1994 and March 1995 as real rates continued to rise (Exhibit 6). Similar patterns were seen post US recessions ended in 1970, 1975, 1980 and 1982.
The defensive sector rotation associated with this phase started in October 2009, and will continue, in our view. We think our portfolio is well positioned already with Staples, Energy and Healthcare as our biggest overweights. Financials and Utilities remain our biggest underweights (see Exhibits 7 and 8).
Risk #2 – Back-up in yields driven by an inflation scare and/or fiscal concerns. While not our current expectations, the risks are worth monitoring, as equities stand to suffer much more than our historical analysis would suggest. While we are not worried about problematic inflation in 2010, we do believe inflation will start an upward trend that could eventually become problematic. Authorities’ higher tolerance for inflation, record amounts of excess reserves that could be lent out and push up money supply, rising commodity prices and a narrowing output gap on the back of sustainable recovery all suggest that inflation risks are on the upside. Inflation expectations have already rebounded strongly to pre-crisis levels, and we continue to monitor inflation risks by watching both the 10-year and 5-year, 5-year forward break-even rates in the US bond markets (USGGBE10 and SGG5Y5Y Index <GO> on BBG), money supply growth and copper prices.
Markets are also likely to become increasingly worried about longer-term fiscal sustainability, given the poor state of government finances in many advanced economies. Because outright defaults are extremely unlikely, as most debt is denominated in domestic currency and governments could instruct their central banks to print whatever is needed, we believe fiscal concerns would be translated into higher borrowing costs and inflation premia in bond markets.
Academic studies have also found that global banking crises are historically associated with a high incidence of sovereign defaults on external debt (see Exhibit 12; and ‘This Time is Different – Eight Centuries of Financial Folly’, Carmen M. Reinhart & Kenneth S. Rogoff). If heightened fiscal concerns, rather than growth, become the main driver of higher rates, we believe the headwind for equities would be more severe than historical analysis would suggest.
We believe gold remains an essential hedge for higher inflation, but sectors that are either the sources of inflation such as commodity-related sectors or have inflation linked pricing including utilities, motorways, airports, bus & rail and satellite should do well (see ‘Hedging Inflation Risks’, 10 March 2008). Exhibit 13 shows that Energy, Staples tend to be the two best sectors in past periods when inflation is high and rising.
Our key takeaway from this analysis. Equities tend to do well when real rates are rising, but there are risks that it could be different this time if higher yields are driven by an inflation scare and/or heightened fiscal concerns. 'Start of tightening' remains our dominant theme of the year, and we continue to expect a consolidation in equities associated with the start of tightening. Market volatility around the start of Asian tightening and announcement of more onerous financial regulations confirms our long held view that the start of tightening could be many things other than the first Fed hike. With the general willingness of authorities to move away from crisis mode in recent weeks, we believe the tightening phase has now started and will intensify, and we expect positive payrolls will lead to a change in Fed language and the start of excess liquidity withdrawal in the next few months. We see 6% downside to MSCI Europe in the next 12 months and recommend selling into strength. Defensive sector rotation associated with the tightening phase has already started in Oct-09, and will continue. Our portfolio is well-positioned with Staples, Energy and Healthcare as our biggest OWs. Financials and Utilities remain our biggest UWs.
And for those who agree with Teun that tightening is in the cards, he provides the following useful checklist to track if indeed the Fed is doing as Morgan Stanley expects:
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