Major potential issues in the 2010 are Profits, China, and Treasuries.
- Liquidity to Profits. The 2009 market rally was fueled by unprecedented amount of liquidity injected into the system by central banks around the world, but this period is coming to close. Some central banks have already started to raise interest rates and more will follow in the 2010 (although we doubt the Fed and the ECB are among them), unconventional programs enacted by central banks are slowly expiring, and impact of stimulus packages is decreasing. There is no doubt that monetary policies around the world are slowly tightening and the liquidity itself is no longer enough to support higher stock prices. It is also important to keep in mind that it is the expectation of the Fed funds rate, and not the actual funds rate, which moves the market, so even if our base scenario of the Fed not increasing the funds rate in the 2010 plays out as expected, the expectation of the rate increases could adversely impact equity markets later in the year.
In the next period, strong profit growth, which we expect to surprise on the upside, is what will support the equity prices and possibly continuation of cyclical bull market in the US. Some strategists, like David Rosenberg, disagree with this view, arguing that it is normal that every percentage point of the nominal GDP growth translates into 2.5 percentage points of the profits growth; since the consensus is for 4% nominal GDP growth in the 2010, and 36% profits growth, things don’t add up. One possible explanation of this inconsistency is the fact that the S&P 500 annualized operating earnings as a percentage of nominal GDP already more than mean reverted (from 6% in the 2007 to 2.3% in the Q3, with the historical mean being 4.2%) and are 2nd lowest in the history (with the low being at 2.1% in the 1992). We expect this ratio will start approaching the historical mean of 4.2% and the profits growth will be much higher than 10%, which is what Rosenberg’s model of 2.5% profits growth per 1% nominal GDP growth predicts. The question remains how much support to the equity prices will the profit growth offer (even if it comes above the consensus of 26%), relative to the support that extra liquidity offered until now. Even if the rally in the US equities continues, we believe it will be much weaker than what we experienced so far, and the end of the cyclical bull market is also a possibility. However, liquidity will offer some support to the equity prices at least in the first half of the year, so we remain slightly bullish.
- Fighting Imaginary Bubbles. The Chinese economy came out of the Great Recession faster and much stronger than almost anyone expected. Low taxes, relatively free economy and high savings rate probably have a lot to do with it – almost a mirror image of trends in the last 40 years in the US! The Shanghai Composite index has gained 85% since its low in October 2008, the real estate prices have recovered strongly, and we expect a strong rebound in exports in the 1st quarter. This strength in the Chinese economy is getting more and more attention and both analysts and the government are getting worried that China is a bubble which might burst in the 2010. It is argued that two distinct triggers might cause the collapse of the Chinese economy – real estate bubble and bad loans made as part of the 2009 stimulus package.
The concerns around the real estate bubble have resurfaced of late, publicized by popular media and some high-profile economists, who are warning of a massive bubble which is ready to burst and would take the rest of economy down with it. In our opinion, these concerns are not warranted, especially in the residential real estate, and while the prices might be frothy in some Tier 1 cities, there is no systemic risk. We will be publishing a more detailed report focusing on the Chinese real estate in the coming weeks, and until then we offer following thoughts:
- China’s real estate market is primarily driven by the massive domestic savings rather than by the bank lending. The main difference between savings-driven and credit-driven bubbles is that the downside risk in savings-driven bubbles is much less dramatic, and there is minimal systemic risk.
- Bubbles are normally driven by overconfidence and generally only recognized in hindsight. However, in the case of Chinese property market, there has hardly been any euphoria, and stories on the Chinese real estate bubble have been abundant in the recent years, both in Chinese and international press. There is a strong sense among households that the prices are heavily manipulated by developers and the prices are at unsustainably high levels; however, the real estate prices remain high and the transactions continue to climb, which might be a signal of the inelastic demand which is forcing buyers to buy into an ever rising market.
- While prices of the Chinese properties have gone up tenfold in the past 20 years, this pales in comparison to the jump in the disposable household income levels. The real estate prices relative to the per capita income have almost halved in the last 20 years.
- The vacant housing units in China have jumped to the all-time high recently, but the inventory-to-sales ratio has tumbled. The new home inventories are currently only about two months of sales, compared to eight months in the 1990s, or nine months currently in the U.S.
As part of the stimulus package enacted by the Chinese government, the banking sector has dramatically ramped up lending in the 2009. According to reports, most of this lending has been “forced”, rather than being based on the free-market principles, and the majority of money went to state-sponsored enterprises. It is argued that this “forced” lending will dramatically increase the ratio of non-performing loans, which poses systemic risk to the economy. We agree that this government-sponsored lending will lead to malinvestment, and in the long term will lead to problems in the state-sponsored enterprises, but we doubt the banking sector will be materially affected. The loan-to-deposit ratio is still hovering at the record low of 68% and the NPL ratio will increase from an extremely low starting point (currently at 1.64%, compared to 24% in the 2000).
While we do not believe any of these pose a systemic risk, the state is adopting a tighter policy, which itself will at least put a ceiling on the equity prices and might easily cause a material correction in the stock market. However, from long-term perspective, we are more worried about government’s involvement in the economy – while the trend in the last few decades was reduction of government’s meddling in the economy, the “success” of the government in handling the Great Recession might reverse this trend.
- Treasuries Bubble. The only major bubble we can identify in the global capital markets is in the U.S. Treasuries – the U.S. government is running huge deficits, and will continue to do this in the foreseeable future, social security and medical expenses are pushing unfunded liabilities through the roof, and the productivity and competitive advantages of the U.S. are plummeting (the only advantage the U.S. still has is its universities, which are still the best in the world), but the U.S. Treasury yields are still hovering at the historic lows. The long-term Treasuries are anchored by the short-term rates which the Fed is still holding around 0%, and they did serve as a safe-haven during the market melt-down in 2007/2008, but it is only a matter of time before investors realize that lending money to the irresponsible U.S. government for 10 years at 3.5% is ludicrous. Once this happens, we wouldn’t be surprised if the yields shoot to double-digits and throw the U.S. economy into a depression, which would finally clean up the system (something which the Great Recession unfortunately failed to do). The problem is with the timing this play – although we are long-term extremely bearish on the Treasuries, we wouldn’t be surprised if they rallied in the first half of the 2010, due to currently extremely bearish sentiment in both the Treasuries and the dollar. For now, we remain out of this play, but continue to monitor it carefully – both because it might provide a historic profit opportunity and because it will likely trigger the Last Depression, when the U.S. financial system is finally cleaned of all its excesses and a new world order is established.
In the 2010, investors will need to be much more vigilant, unconventional, and willing to move in and out of opportunities faster than usual. The breadth will decrease, and stock picking will once again be extremely important, as well-run companies can do extremely well even if stock indexes turn south. While some countries (Brazil, Chile, Taiwan) or sectors (we like Asian real estate) might do well, the emerging markets are at a risk due to the huge rally in the 2009, the potential problems with China, and the extremely widespread bullish sentiment. Long-only strategies will likely not do very well, and it will be important to seek alpha through relative plays (some ideas include long S&P 500/short S&P banks, long crack spreads through U.S. refiners, long Dow/short NASDAQ, and long Platinum/short Silver). Contrarians should take a look at Japan, where the new administration failed to make any changes, and where the sentiment is extremely bearish. We will expand on these themes in the coming reports, but the general theme in the 2010 will be capital preservation, achieving profits from alpha rather than beta, and being nimble.
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