19 July 2011

FX Strategy
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The end of the super-cycle?

The promise of eternal youth has been dashed again
kit.juckes@sgcib.com kit.juckes@sgcib.com

The economic recovery that followed the credit crisis has an alluring quality - the hope that with the help of ludicrously low rates and a hefty dose of money-printing, we might actually have found the economic equivalent to the secret of eternal youth. Where we feared that the mad credit binge we had embarked upon in the years running up to 2008 might be followed by the mother and father of financial hangovers, lasting for many years, what we got was a reasonably robust rebound. Any potion promising eternal youth should come with a warning about side-effects. And in this instance, I dont just mean that sterling is so weak we are faced with spending the summer in the rain, and Switzerland a country I can no longer afford. You can see side-effects in the nearly $10trn in foreign exchange reserves that have been accumulated by banks desperate to prevent their currencies from appreciating against the dollar. You can see it in real estate bubbles in Hong Kong and Singapore and in an equity bubble in Brazil. Over the last few days another side-effect has been bothering me the accelerated lurch by financial markets between greed and fear. Weve got a new term for those two moods risk on and risk off. We put a chart in a recent Weekly of the volatility of the SG risk sentiment indicator, which has never been this high before. This has been bugging me because it brings to mind an image of a plate-spinner, spinning his plates faster and faster in an attempt to avoid an inevitable crash. The instability that gyrations in risk sentiment reflect is a function of the absurdly easy monetary policy that helped the US and G7 economies avoid a far deeper recession. And because the cure that promised to extend the economic cycle ad infintum is itself the cause of mounting instability, it seems increasingly clear it contains the seeds of the next catastrophe. The hope that we can go on enjoying painless de-leveraging and an extended upswing, is looking increasingly far-fetched. Risk appetite is becoming increasingly unstable
0.8 0.7 0.6 0.5 0.4 0.3 0.2 0.1 Aug-04 5% 6% 7% 8% 9% 10% 11% 12% 13% Aug-06 Aug-08 SG risk sentiment indicator, 3m avg (lhs) 3 month stdev of daily changes (rhs, reversed) Aug-10

Source: SG Cross Asset Research

Macro

Commodities

Forex

Rates

Equity

Credit

Derivatives

document Please see important disclaimer and disclosures at the end of the document

The end of the super-cycle?

superThe debt super-cycle, a short summary

Most of the period since 1985, has been characterized by rising wealth levels, courtesy of falling real interest rates and increasing debt levels in the worlds biggest economies particularly the Anglo-Saxon ones. Globalization helped keep down labour costs. Technological advance has changed the world we live in beyond recognition. But the legacy of the defeat of inflation has also been lower and lower real interest rates and with that, higher and higher levels of debt. Credit ratings have drifted lower as companies have sought to make better use of their balance sheets. Households have accessed cheap credit and taken advantage of financial innovation to take on mortgage, arguing that as long as the debt is offset by assets, its fine. The upshot was that although the economic cycle continued, recessions were mild and overall levels of wealth continued to move higher. Whether you call this the great moderation or the debt super-cycle, the temptation was to believe that the economic cycle had been tamed, replaced by a super-cycle where life could just go on getting better and better.

And then there was 2008

No sector of the economy did debt as well as banks. Its an industry where big is almost always best more efficient, able to deliver more services to customers and able to take on bigger risks in order to transact business. And if debt is cheap, a bank can borrow more money and grow its balance sheet in order to make the return on equity go up and up. Return on capital was for wimps by 2008. Securitization allowed banks to lend to mortgage borrowers and distribute that debt to investors. Structured credit allowed banks to package leveraged loans together, selling equity, mezzanine and senior slices to different investors. The asset-backed commercial paper market even allowed some of those investors to fund their investment with the help of banks who were supposedly getting the loans off their balance sheets. Madness ruled.
Back to the 1970s - real rates have been falling since 1984

Real 1yr Tsy yield

10 8 6 4 2 0 -2 -4 -6 -8 53 55 57 59 61 63 65 67 69 72 74 76 78 80 82 84 86 88 90 92 94 97 99 01 03 05 07 09

Source: SG Cross Asset Research

A magic trick
When the whole credit edifice came crashing down, taking Bear Stearns and Lehman to the scrapheap, RBS and Lloyds to the Treasury, it seemed inevitable that the super-cycle, and the great moderation, were over for good. We all prepared for the Great Recession and the even greater de-leveraging. A future with lower leverage, and more regulation was inevitable.

19 July 2011

Then, as if by magic, along came a wizard who would not have looked out of place at Hogwarts. Fed Chairman Ben Bernanke gave us even more negative real rates, supplemented by explosive growth in central bank balance sheets, and debt was simply transferred from the private to the public sector. The recession was severe, but much less awful than our worst fears. The super-cycle was back in business.
postdeThe post-crisis de-leveraging hasnt even started....

260

US non-financial debt (%GDP)

240 220 200 180 160 140 84 85 86 87 88 89 90 91 92 93 95 96 97 98 99 00 01 02 03 04 05 06 08 09 10

Source:Bloomberg

And now
My stock response to questions about the long-term cycle nowadays is that I dont know if this is the last cycle in the super-cycle, or the second-last, or the third-last and so on. I have started to believe in the economic equivalent of eternal youth. The market consequences were that as long as the US ran lower rates and more QE than anyone else, and as long as the developed economies saw growth hampered by de-leveraging while those in EM saw growth boosted by importing low US rates, we should expect asset bubbles to grow in emerging economies, the dollar to fall against any currency which was allowed to appreciate against it, and global FX reserves climb to unimaginable levels. We should also expect equity markets in general to do much better than might seem sensible from a simple look at underlying G7 economic growth. The price of all this is increased instability in financial markets. There are almost USD 10trn in global currency reserves now. Reserve mangers have become the biggest players in FX markets and sovereign wealth funds own everything from banks to football teams. Credit is too cheap but heavily rationed. Germany can borrow at rates which are out of line with a strong economy. Greece cant borrow at all. The cost of a mortgage has gone up, while the cost of funding to a single-A corporate has collapsed. Investment grade companies are hoarding unprecedented amounts of cash, because they can, while we argue whether countries in Europe are facing a liquidity crisis or a solvency crisis (both). And we have even invented a new term for the way markets lurch from despair to delight as they focus either on cheap money or the scale of the debt burden we still havent managed to get to grips with Risk on, risk off.

19 July 2011

The end of the super-cycle?

The soft patch, and the vol of risk

In recent weeks, my biggest fear has been that despite the level of rates, and despite the fact that the US doesnt even have to tackle the size of the countrys debt (they just have to agree to increase the debt ceiling, for goodness sake!) , the economy would slow sharply anyway. This is the fear of the monster under the bed or what happens if Goldilocks meets the Big Bad Wolf. Theres no compelling logic that says this MUST happen and we continue to hope that the soft patch is just that, but if even these policy settings cant keep the super-cycle going round, were in trouble. And lets face it, US economic data are still surprising on the downside, day after day. I have also worried that Europes leaders will fail to keep the euro project alive. Wise men such as Werner Sinn at IFO argue that Greece leaving the euro temporarily would be good for both Greece and the Eurozone. Europes politicians want to avoid a Greek default but also want private sector participation in a bailout, which rating agencies may reasonably term a selective default. And the ECB continuously warns that creating a situation where Greece defaults could cause dominos the size of skyscrapers to fall across the world. Contagion to other sovereign borrowers, to lenders everywhere, and a massive crisis of confidence would follow. Who would deliberately engineer such a situation? But even assuming these twin disasters can be avoided, the dizzying lurch from risk on to risk off and back makes this cycle look very much like the last one before the long deleveraging takes over. Cheap money is simply causing too many unintended consequences and too much instability. None of this makes me like the dollar or the euro. It doesnt stop me hoping that we can build a world where there is enough demand from the emerging economies to allow a re-balanced global economy to continue growing. But it does make me increasingly nervous that we will see a fresh major - bout of market unrest before the year is out. If the current US soft patch proves itself to be nothing more sinister, and if the European summit this week can deliver a strong enough bailout for Greece to allow markets to focus elsewhere for a few weeks, maybe the conditions for a summer risk rally can be put in place. If thats the case, enjoy the rally. It may be the last one we see for a while.

19 July 2011

CROSS ASSET RESEARCH FIXED INCOME & FOREX GROUPS

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Nalini Cundapen (44) 20 7676 7491

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Guillaume Salomon (44) 20 7676 7514

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Technical analysis Hugues Naka (33) 1 42 13 51 10

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Fabien Manach (33) 1 42 13 88 35

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19 July 2011