Friday, 08 November 2013

Summary

Important stock indices such as the S&P 500 and the DAX 30 are headed for new all-time highs especially now the ECB has lowered its key interest rate. Investors are becoming euphoric, growth is picking up, and the authorities are tackling the major imbalances that prompted the credit freeze and the euro crisis. And yet, a warning is in order. Bubbles are in the air. Insufficient investment and an aging population lead to a decline in potential growth. Meanwhile, central banks are stacking debt on debt. This combination is only sustainable as long as interest rates are very low. Investors are inclined to take more and more risks in the expectation that central banks will not raise interest rates for another while. Ballooning indebtedness and lower potential growth are a dangerous combination. We foresee mounting Eurozone tensions in the coming months. This may well be "necessary" to bring together the strong and the weak Eurozone countries and force them to form a banking/fiscal union. On balance, US economic growth is on the mend. In the months to come we expect more tapering speculation. Simultaneously, the Fed could engage in forward guidance. Stock prices seem to have upward potential until the end of the year but in 2014 a bear market could start. Owing to higher US growth and speculation that the Fed will scale back its bond-buying program, the yield on 10-year US Treasury Bonds could climb to 4% over the next few quarters. The 10-year German yield can target 2.25% on mounting Eurozone tensions. In our view, EUR/USD will not rise beyond 1.38 for the time being. In the coming quarters, it could slide to 1.20 due to Fed tapering, higher tensions in the EMU, and pressure on the ECB to ease its policy.

Beware the Bubbles ... True or False?

Several major asset managers (among others, PIMCO and Black Rock) think that the ongoing stock market and (risky) corporate bond rallies signal that bubbles are emerging. Mainly because central banks have created "free money" and have driven down interest rates on low-risk assets. This has pushed many investors into riskier assets. The ECB's latest rate cut reinforces this tendency.

A weak domestic currency tends to boost a country's export sector and economy; therefore the Chinese central bank bought massive amounts of dollars as it sold money denominated in yuan.

On the other hand, many large European and US businesses are highly profitable and their balance sheets are strong. Generally speaking, a combination of rising stock prices and upward pressure on bond yields heralds higher growth. Considering that various fundamentals underpin the upward pressure on stock prices, is there really any need to fear bubbles? In this GFM report, we will juxtapose the arguments for and against the warning that bubbles are being inflated in the asset markets. We will focus on the longer-term prospects and outline the scenario that we think most likely. Plus, its implications for asset prices over the coming months or quarters as well as the prospects for bond yields and currencies.

Next, most of these dollars were recycled in the US capital markets, which put downward pressure on long-term interest rates in the United States. This effect was reinforced because US inflation eased due to cheap imports from China, whereas US workers were suddenly faced with the threat that production would be outsourced to China. This limited wage increases, while wages stagnated in real terms. In the decades leading up to the credit crisis, such factors added to the downward pressure on inflation and bond yields in the US. Consequently, the Fed could pursue an ultra loose monetary policy and it became an increasingly attractive proposition to borrow money in order to buy property. Although real wages were not going up, due to rising housing prices and low interest rates, US consumers could spend progressively more on credit. Because the yuan was pegged to the dollar, the Chinese central bank was forced to pursue a monetary policy that was almost as accommodative as the Fed policy. However, growth was significantly

Global imbalances are decreasing

Around the world, we see fewer imbalances of the kind that helped trigger the credit squeeze and the euro crisis. As a result, investors have less need to fear bubbles. This is why the longterm growth expectations are fairly positive. A well-known imbalance was China's policy to keep the yuan artificially low against the dollar.

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higher in China than in the United States. On top of this, Chinese investors were not allowed to buy foreign assets so money supply growth in China was substantial. Most of this capital flowed into the Chinese asset markets (the housing market and, until October 2007, into the stock market as well). Investment boomed and there was an enormous hunger for commodities. This was a bonus for important commodity producers such as Australia, South Africa, and Brazil (although there was a downside: a growing dependence on commodity exports). This led to major imbalances. The US imported more than it exported and debts hit the roof. In contrast, China had a large trade surplus and accumulated enormous (dollar) reserves. This pattern continued until 2008. Following the credit crisis, US consumers started to deleverage and the trade deficit narrowed. Another reason for the improved trade position of the United States has been a considerable increase in energy extraction in while businesses have become more competitive.

Presently, China is trying to move away from export-led growth and is boosting domestic consumption. To this end, it allows the yuan to appreciate more. Wages are on the rise while the government is attempting to gradually rein in credit supply that is geared to (over) investment and property purchases. This week, the Communist Party has scheduled a large meeting that will probably result in further measures towards a consumptiondriven economy. In other words, the imbalances that gave rise to the credit crisis and caused asset prices to plunge are being redressed.

Tackling Europe's structural problems

The imbalances in the EMU that gave rise to the euro crisis are comparable to the China-US imbalances discussed above. In the years before the introduction of the euro (and subsequently as well) capital flowed into the weak EMU countries. Investors expected Eurozone regulations to force these member states to follow in the footsteps of Germany when it came to

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economic policy. That is to say, a focus on budget discipline and low inflation, instead of an approach whereby domestic currency devaluations, allowing higher inflation, and increasing indebtedness would gloss over the structural economic shortcomings. In other words, investors could look forward to easing inflation and lower long-term interest rates without the risk of a strongly devaluating currency. The result was a considerable inflow of money into the countries in question, which put upward pressure on asset prices and created an economic boom. Germany was in a different position. Previously labeled the "sick man of Europe", after the introduction of the single currency the country reshaped its economy and labor market in a structural way while wage increases were modest (in the weaker Eurozone countries, wages rose faster). Nor did German bond yields plunge while asset prices and credit supply were boosted less than elsewhere in the Eurozone. Domestic demand stagnated but Germany's competitiveness improved, especially in relation to the peripheral Eurozone. Therefore Germany started to export more and is running substantial trade surpluses. The euro crisis marked the beginning of the end of a process whereby the debt-laden EMU countries became ever more inefficient whereas economic growth was heavily reliant on asset price rallies and exploding debt. Now the respective member states are implementing structural reform measures with varying success as they try to reduce indebtedness and generate growth based on exports. This is a painful and difficult course of action but in due course, economic stability should improve.

Citizens and (local) governments in what came to be known as the problem countries went on a borrowing spree and started to consume far more than the economies produced. Consequently, the peripheral Eurozone countries saw high economic growth, without the need to deal with the structural defects of their economies. At the same time, trade deficits increased as debt exploded.

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Low interest rates help to redress imbalances In other words, the major imbalances are decreasing (between China and the US and across the EMU), which led to plunging asset prices and a number of crises, are being put right. However, it will be a while before a new equilibrium evolves. To bridge this difficult period, central banks have opted for an ultra loose monetary policy, which has boosted growth (or perhaps we should say it has staved off recession). An accommodative monetary policy also drives down interest rates, which is good news for debtors to the detriment of creditors. In fact, the implication is that China and the strong EMU countries (major creditors) are subsidizing big debtors such as the US and the troubled Eurozone countries. This is a way to redress the imbalances. Simultaneously, it turns out that during this transition stage businesses continue to gain profitability as they streamline efficiency and earn more in the developing countries, including China, that want to foster consumption. On top of this, resource prices have dropped in recent years, which impacts positively on economic growth. From this perspective, it is no surprise that the prices of many assets and corporate bonds are (almost) at record highs. Whereas prices nosedived after the credit and euro crises, timely interventions by central banks and governments have prevented a global Armageddon scenario. That the imbalances appear to be disappearing could boost growth in the long term. Also encouraging is that housing markets in many countries are recovering and that forward-looking indicators (like the ISM and the PMI) point to recovering growth around the world.

developments give rise to fears of market bubbles. Let's start with the long term. A major risk is that the authorities will continue to pursue a policy that stacks debt on debt until a larger credit crisis is inevitable. Regular recessions can have a positive effect, in the sense that many inefficient businesses vanish as bad debts are restructured. Banks and investors take this into consideration when they demand adequate risk premiums. This creates a buffer that offsets the losses associated with a recession. Since the 1980s, recessions have become less frequent and milder. Largely because of the aforementioned downward pressure on inflation and long-term interest rates. Each time a recession hit, central banks were able to flood the system with liquidity. This sent asset prices higher and credit continued to ease. Because consumers felt wealthier, they were happy to spend more. In the decades before the credit crisis, property price rallies marked the start of most economic recoveries in the US. Staving off recession has a downside One of the consequences was a growing belief that it was possible to control the economy. The belief gained ground that monetary and fiscal stimulus in just the right dose can alleviate or avert painful and unpopular recessions. There have been a number of side effects:

Why bubbles are a real risk

Inefficient businesses could hang around for longer and not enough bad debts were removed from the financial system. In combination with easing credit, this meant that debts continued to accumulate. Banks and investors are less and less inclined to take into account the possibility of default. As a result, risk premiums have dropped and the buffers to offset potential losses have dwindled, relative to the scale of the debts.

Of course, the aforementioned positive factors are offset by worrying developments. Major asset managers have good reason to warn of the downside risks of emerging bubbles. In the short as well as the long run, a number of

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To some degree, all of this was self-reinforcing. The higher the debt, the longer the bad debts remain stuck in the system and the lower the buffers (as a percentage of the outstanding debts). And: the higher the risk that a recession will develop into a full-blown financial crisis. In itself, this puts increasing pressure on central banks to ease their policies in order to prevent recession. Pressure on potential growth In practice, this means that central banks are pursuing a policy that creates more debt because they want to minimize the risk of recession and financial crisis. One consequence is that debtservicing commitments are on the increase. As long as the latter lags economic growth this is not a huge problem. Yet, it is very dangerous because there is downward pressure on potential growth:

on to find money elsewhere. Often, in the areas of education and infrastructure. This too, impacts negatively on future growth.

Finally, the job markets in Europe and the US are only improving slowly; many young people have been out of work for a long time. If this continues, many of them will become unemployable; there will be a "lost generation" that is excluded from the labor market.

Populations are aging in Japan, but also in Europe and to a lesser degree in the US as well; increasingly so. Now that the economy recovers, the time has come to gradually normalize the unprecedentedly loose monetary policy and reorganize the public finances (additionally). If growth continues to pick up, the authorities will jump at the chance to tighten the monetary and fiscal policy. In all likelihood, this will cap growth in the years to come. Interest rates that are close to zero (a feature of the current monetary policy) increase the popularity of stocks issued by companies that pay dividends or buy back their own shares. In turn, this encourages businesses to use their profits to lure investors rather than to increase investment. This bodes ill for future growth. Governments meet a lot of opposition if they need (or want) to implement spending cuts at the expense of social security. So the pressure is

In fairness, none of this is written in stone. Major technological breakthroughs could occur that boost the labor productivity per worker. If so, potential growth will soar and many downside risks will simply dissipate. At the moment, we see various technological developments that could potentially be significant (such as 3D printing, medical developments that enable people to live healthier lives for longer, and so on). Nevertheless, as yet few economists see the scope for much higher potential growth in the next few years. Such developments will only take effect after a good while.

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economic outlook after long-term interest rates started to rise). Based on limited growth prospects, central banks will have to pursue an ultra loose monetary policy for as long as possible. This forces investors to purchase riskier assets and to accept lower returns, instead of obtaining higher risk premiums as a buffer against future losses. In the circumstances mediocre growth expectations and high indebtedness losses could increase substantially. Particularly if interest rates start to soar. We think there is a high risk of rising long-term interest rates. Expansionary central bank policy has created a vast liquidity reservoir. This money is still stuck in the banking system or has flowed into the financial markets. Now that global growth is improving (because higher asset prices are boosting credit supply), it only seems a matter of time before more capital flows to the real economy, where it will put upward pressure on growth and inflation expectations and drive up long-term interest rates. We fear that central banks, as they try to bridge the time it will take to redress the imbalances, are creating fresh asset bubbles. Meanwhile, many governments are doing little, if anything, to put this interim period to good use and take measures to boost potential growth. The key question is will these bubbles (in the stock and corporate bond markets as well as in some countries the housing markets) continue to grow and when will they burst? Several indicators suggest that end of the rallies is in sight:

In a climate of mounting debts and downward pressure on potential growth, indebtedness could weigh heavily on the economy, which carries the risk that a new credit crisis will break out. This makes it vital to keep interest rates as low as possible in order to boost growth. This, too, has a downside. Low borrowing costs remove the incentive for governments to push for painful structural reforms or get on top of the public finances; borrowing is a far easier option. New bubbles Minimal rates of interest and the fact that central banks can barely afford to let interest rates go up increase the risk that bubbles will emerge:

Such factors encourage speculators to use more leverage, in order to increase their returns. Low interest rates force savers and investors to purchase ever riskier assets in order to earn serious money. Because high asset prices are crucial to the economy, investors are under the impression that central banks will ride to the rescue as soon as prices threaten to plunge or interest rates go up too much. Even more so after the Fed refused taper in September (due to a deteriorating

The number of analysts and investors who expect stock prices to drop (sharply) is at a historically low ebb. Equally, the low VIX and put/call ratio imply that few investors expect pullbacks. This often means that the opposite is set to happen.

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According to various benchmarks, stock prices are becoming overvalued. Small investors are purchasing equities on a massive scale. This tends to happen towards the end of a major uptrend. The market for IPOs is booming. Particularly technology companies Twitter! go public at absurd valuations.

This is offset by the fact that, in terms of points, the rally since March 2009 is the largest rally in the S&P 500 but one (another reason to tread cautiously). In view of the scope of the uptrend, an extended peaking phase would not surprise while the mood could become even more upbeat.

Market trend reversal due to Europe?

Our in-house team of analysts regularly discusses what could trigger a bear market in (risky) assets. Below we have listed some of the "candidates" that are put forward:

Rising inflation expectations on the back of the ultra loose Fed policy. These will drive up oil prices and long-term interest rates until the Fed can no longer continue with its current QE policy, as this would fan inflation fears. In that case, the central bank will have to tighten its policy even if the US economy is not ready. There is a possibility that the economy will respond less and less to the Fed's monetary intervention. If so, the drawbacks of the Fed policy will soon outweigh the benefits. Japan and China could present some unpleasant surprises. Japan is carrying out a gigantic monetary experiment in an attempt to

eradicate deflation after many years. To this end it is printing a lot of extra money, which could prompt a yen crisis, at least in theory (see also last week's GFM report). Apart from doubts about the official growth estimates released by China (which might be too optimistic) the stability of the country's bank system gives cause for concern. China is the second largest economy in the world while Chinese indebtedness has risen to levels (as a percentage of GDP) where the risk of a credit crisis starts to increase rapidly.

Rising Eurozone tensions.

Europe opts for a "deflationary trajectory" Lately, we have been receiving emails from readers who think we may have become too pessimistic about Europe and too optimistic about the US. Although most other research points in the same direction, these comments are understandable. After all, under pressure from Germany in particular, Europe is pursuing a policy that aims to get the member states to "swallow the bitter medicine" and improve growth prospects across the board, albeit through painful restructuring.

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Owing to these vicious cycles and the expensive euro, the governments of the distressed EMU states face an uphill struggle if they try to improve competitiveness via structural reforms, while trying to underpin the export sector and growth in general. Viewed in this light it is quite an achievement for the authorities in for example Spain, Portugal, and Ireland to implement measures that really hurt without huge social upheaval (which might be one reason why it pays to be positive about Europe in the long term). As long as the weak Eurozone countries are struggling and the euro is (too) strong, we cannot rule out another euro crisis. However, Germany and the other rich member states could help the "weaker brothers" if they:

In contrast, the US opts predominantly for the easy way out as it floods the system with maximum liquidity. Although the US has the advantage of expanding energy exploitation, whereas its population is not aging as fast, there is a fair chance that the US, too, will need to "bite the bullet" at some point. This will put downward pressure on US economic growth. Perhaps by that time, the situation in Europe will be improving. On the other hand, because Europe has chosen a "deflationary trajectory", its growth prospects will continue to be fairly pedestrian in the coming quarters. Also relevant is that the European banks will be subjected to stricter regulations. This forces them to strengthen their balance sheets. Especially the banks in the ailing member states will be able to supply less credit to the real economy and they will need to purchase more government securities. Finally, although the ECB's policy is accommodative, it is tighter than the ultra loose monetary policy of other major central banks and the euro is too expensive. This means that monetary conditions are restrictive in the weak Eurozone countries, where interest rates are above the rate of economic growth. The end result is a downward deflationary spiral in the debt-laden Eurozone countries where indebtedness (as a percentage of GDP) continues to increase.

Allow the ECB to pursue a much looser monetary policy; this will weaken the euro substantially. Write off part of the outstanding debts. Subsequently, interest rates can fall; there is a high chance that this will stop the downward spiral in its tracks. In our view, this would be a structural solution for the ailing economies although the stronger EMU countries would sustain considerable losses, which their citizens are not prepared to accept. Ease their own fiscal policies, so the struggling countries can export more.

Germany sticking to its guns For now, Germany does not want to go down this road. It fears higher inflation in Germany (if the ECB eases its policy too much). Plus, Berlin does not want to offer the debt-laden member states an easy excuse not to implement the required structural reforms (or postpone these measures indefinitely). In addition, the German government intends to embark on deficit reduction, in anticipation of the higher public spending as the population ages. Therefore an accommodative fiscal policy is unlikely.

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The strong countries think there is a need to write down old debts but for the moment, they do not want this to apply to the official bailouts. In other words, they mainly condone write-downs in the private sector. The ECB, which is due to supervise the big banks, should initiate this process. In preparation, the central bank is scrutinizing the bank balance sheets while next year, it will carry out stress tests. Banks that do not have enough reserves or are saddled with many bad debts will be forced to attract more capital and, if needed, to write off nonperforming loans. If a bank fails to do this of its own accord, first the shareholders and the subordinated bondholders of the bank will receive a haircut, followed by the government in question. Only as a last resort will the bank be able to apply to the European emergency fund. The ESM can avail of 60bn to recapitalize the distressed European banks. However, the IMF expects more than 200bn worth of losses for the Spanish and Italian banks in the coming two years. So if the banks need more money than the ESM can provide, the governments will have to chip in. The problem is that this will restore the "toxic link" between the banks and the governments of the weak Eurozone countries. Precisely this unhealthy connection has created a lot of tension across the EMU over the past years and sent bond yields higher in the periphery.

All the same, Eurozone tensions have eased in recent quarters. Contributing factors were, among others, the Fed's QE policy (which prompted investors to purchase higher-yielding European assets) and a period of political calm in the runup to (and the aftermath of) the German elections. At the same time, we foresee more tapering speculation in the coming months. On top of this, the ECB has eased its policy this week, which means investing in Europe is becoming a less attractive proposition. Moreover, we think a new German government will take office in the coming weeks, quickly followed by further negotiations about a banking and fiscal union (a political minefield). In combination with the pressure on the banks to adjust their balance sheets, this could fuel the tensions in the euro area. Before long, bond yields in the debt-stricken countries could be on the rise as asset prices fall while the euro continues to depreciate. In one respect higher Eurozone tensions may have a positive effect; they could put huge pressure on the governments to take the muchneeded steps towards a fiscal and monetary union and urge the ECB to pursue an (even) looser policy. In other words, the EMU will only integrate further if the financial markets exert pressure. This could minimize the risk of mounting tensions and improve the long-term growth prospects considerably. Back to summary ^

Implications for the financial markets

Earlier in this report, we have explained our expectations for the asset markets and the euro:

We believe that bubbles are emerging in the main asset markets in the US and Europe as well as in the markets for risky corporate bonds. In all likelihood, there will be some upward potential in the

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coming months, interspersed with corrections. However, we do not think the S&P 500 will rise much beyond 1,850 while the DAX 30 could peak near 9,500.

Early next year, we foresee a bear market on the back of tapering speculation in the United States and mounting tensions in the EMU.

The prospect that the Fed will scale back its bondbuying program plus higher Eurozone tensions could drive down EUR/USD to 1.20. A pullback to below 1.30-1.31 would confirm that the downtrend has started. There is a high chance that EUR/USD will stay below 1.383 for the foreseeable future . Particularly now the ECB has cut its rate sooner than analysts were expecting.

economic data point towards a durable recovery. Simultaneously, there are signs that the Fed wants to apply more forward guidance; possibly by indicating that it will wait until jobless rates have dropped further before starting to raise its official rate. So far, the US central bank has suggested that it will not consider a rate hike as long as unemployment exceeds 6.5% but it could lower this threshold to 5.5%. If so, US interest rates will remain lower for longer. Essentially, this would impact negatively on the dollar. We should not forget that the European banks may want to improve their balance sheets in the coming months, by selling assets outside the EMU, which will boost euro demand. If the US data disappoints simultaneously, EUR/USD will likely rise further. Even so, we do not think it will break through 1.38. Under such conditions, there will be mounting pressure on the ECB to ease its policy. However, we expect the US economy to improve gradually. In that case, the Fed could start to taper before long and the downtrend for EUR/USD will fitfully continue. Bond yields Should the Fed really engage in more forward guidance (it could indicate that it will not raise its benchmark rate until unemployment has fallen below 6%-5.5%) the central bank will stay behind the curve for the time being and tolerate temporarily higher inflation, if need be. Whatever the immediate effects, eventually rising inflation expectations will take their toll. We anticipate higher underlying economic growth in the US in the coming months. Among others because of an easing fiscal drag and the positive impact of lower oil prices, (mortgage) interest rates, and high asset prices. This is offset by the supposition that due to restocking Q3 growth may well have been higher than expected. That is to say, 2.8% instead of 2%. In Q4, when part of these inventories are used, growth could be lower. Yet, on average we believe that growth will continue to improve unless the US politicians start to push for another shutdown. The

Easing inflation in October (to a surprising degree) plays an important part. Euro strength is the main cause of lower inflation. In other words, the ECB's rate cut is a signal that the central bank is no longer prepared to tolerate the appreciation of the euro. Yet, the risk that EUR/USD will rise has not disappeared. In the past weeks, the Fed has clearly indicated it is only prepared to unwind QE if the

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latter seems unlikely. Consequently, the yield on 10-year US Treasury Bonds could reach 3% in the coming months and then climb to 3.5%-4% in the course of next year. The yield on 10-year German government bonds (now near 1.7%) could move along similar lines. There is a fairly close correlation between bond yields in Germany and in the US. This week's ECB rate cut is good news for the Eurozone and German economies; so is the resulting downward pressure on the euro. Bond yields in Germany will probably lag those in the US in the light of growing Eurozone tensions over the coming months. In response, more investors will seek a safe haven in the German capital markets, which will mitigate the upward pressure on German long-term interest rates. On balance, the German Bund yield could climb to 2.25% in the quarters ahead.

Back to summary ^

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