Outlook for 3Q 2012

EU deleveraging will continue for the foreseeable future. Output may bounce following re-leveraging policy actions, but the bounces will be weak. In the EU and US, demographically driven dis-saving occurring in conjunction with central government deleveraging means growth and inflation will remain subdued.

One question is how much additional policy easing can help growth across the world. The lessons from Japan suggest that the answer is ‘not much.’ The limitations of additional monetary and fiscal easing are a key risk to equity markets which is only somewhat priced in via the skew in option implied volatility. As this becomes accepted, markets are likely to react more to economic data and less to policy changes. The skew is also not likely to subside much.

Over the rest of the year, the global slowdown that started at the beginning of Q2 looks likely to continue through the end of Q3. The tightening in credit that began a year ago continues to have negative effects on economic growth. In fact, after easing in Q1, credit spreads in some sectors are now near the peaks touched last October. And of course, the uncertainty around the fiscal cliff is also a factor. In aggregate, these effects are likely to reinforce defensive attitudes across the US, which in turn is likely to cause companies to put off capital expenditures and hiring new employees. The impact on corporate profitability is already being reflected by the number of negative earnings guidance issued over the past month.

However, an outright recession in the US as of yet appears unlikely. One of the silver linings of the multiple growth scares of the past couple years is that the build up of operational and financial leverage that often proceed recessions are absent. Of course, the major caveat to the recession outlook is if congress mis-manages the budget deficit. Some sort of fiscal tightening is likely by 4Q of this year – the main question is how much.

The Japan template suggests that G4 (ex Japan) 10y yields will remain between 1.25-2% for an extended period. 10y yields much above 2.25% will simply be too high given the economic backdrop, and central banks are likely to act to correct such occurrences. Note that the current EU template is quite similar to the Japan template post bust. In both instances, authorities flooded the banking system with liquidity without requiring quick writedowns of loan losses. The net effect is that the deleveraging process is stretched out over many years.

The likelihood of another growth / recession scare this summer suggests that yields are likely to approach the lower end of that range. As a result, long fixed income positions expressed via risk reversal type structures look attractive.

Note that in the US, the number of earnings misses last quarter hit the highest level since early 2009. Furthermore, profit margins are very close to the highs from 2007. They were driven there by multiple macro economic factors that appear to be peaking / reversing, including low interest rates, low effective taxes, large federal budget deficit, and the weak USD. While profit margins and profits as a percentage of GDP may not revert to the long term mean in the near future, it does suggest that the balance of risks is very likely to the downside.

In Europe, obviously the macro backdrop is even worse. However, the relatively cheaper valuations make the picture more complicated. The volatility there suggests that opportunities for inter-EU trades may arise. Valuations for Japanese equities actually appear to be on the cheap side. The earnings bump from the tsunami rebuilding and a possibly more active MoF suggests that the Nikkei could re-rate, if only temporarily and on a relative basis.

Nevertheless, given the weak macro economic backdrop, outright directional equity risk should probably be flat or marginally short / defensive.

The global backdrop suggests the risk on / off dynamic is likely to continue. As a result, many FX crosses are not likely to offer much in terms diversification benefits against equity exposure.

One exception is USDJPY. Policy maker statements suggest that downside is limited, while upside risks are likely capped by the structural backdrop. Option strategies to take such a view include strangles, iron condors, or butterfly structures. Unfortunately, the low levels of implied volatility mean that the trades may only be worthwhile at longer maturities.

And of course, this outlook wouldn’t be complete without a view on EURUSD. Unlike many market participants, I think it is likely to be range bound. The main reason is that the main rationale for a lower rate – capital flight – is likely incomplete. This is because the EUR is a reserve currency, and as such, is used as the currency for global liabilities. The delevering and repatriation during times of stress tends to offset outgoing capital flows to a large degree. Market action also seems to suggest capital flight out of the EUR into USD is limited. Standard OLS models using only interest rate differentials continue to have good explanatory power for the cross. This view also appears somewhat supported by the options market, as the skew has retraced from the lows.

Oil prices appear to be in a new range. Longer term, there isn’t too much more downside simply because the global marginal cost of production is at or above current levels.

Regarding gold, one useful point to consider is that all money is not created equal. A dollar printed when the 10y risk free rate is at 5% is much more expansionary than when the rate is at 1.5%. Given that global central banks appear to be nearly out of ammunition, the ‘buy gold on global money printing’ trade is also likely over. Finally, note that the fear of a banking crisis is negative for gold. As the post Lehman price action showed, forced deleveraging scenarios often divide assets into 2 classes: cash and non cash. Despite Ron Paul’s proclamations, gold is not cash.