How Markets Could Shift to ‘Risk Off’A. Gary Shilling
Feb. 1 (Bloomberg) -- The huge deleveraging in private sectors in the U.S. and elsewhere, the unresolved frictions between northern and southern nations in the euro area and the needed shift in China to a domestically driven economy suggest that the current “risk-on” investment environment may collapse.
Bullish investors will probably be forced into an agonizing reappraisal by a shock, as was the case in limited ways with the euphoria over the Federal Reserve’s first two rounds of quantitative easing and its Operation Twist, which involved swapping short-term debt for long-term securities.
The first outbreak of the Greek debt crisis in early 2010 ended the QE1-driven stock rally. The QE2-spawned bull market ended in early 2011 with the second round of Greek turmoil and the widening European financial and economic woes. Operation Twist optimism concluded with the realization that Europe’s problems may not be amenable to a ready solution, and with investors’ worries about the U.S. political deadlock over the automatic spending cuts and tax increases scheduled to take effect Jan. 1.
This time, a hard landing in China might do the job. A slowdown to growth of 5 percent to 6 percent would have dire consequences for world trade, commodities demand and prices, as well as commodity producers and their currencies. A hard landing will be a big shock to analysts who interpreted recent data, such as the pop above 50 in the HSBC Purchasing Managers Index, as insurance that a soft landing has been achieved and that a return to 8 percent real gross-domestic-product growth rates is imminent.
The trend in all-important export growth is still down, and China is far from a domestic-led economy with only 38 percent of GDP accounted for by consumer spending.
Investor euphoria could also be shattered by a leap in the price of oil, triggered by an Iran-related incident. That is what unfolded in 1973, when the Arab oil embargo deepened the recession, and with the Iranian revolution in 1979. A significant energy-cost surge would be a debilitating tax on consumers.
Another cause for a shift in sentiment would be the failure of a major European bank, which -- despite the European Central Bank’s commitment to bailouts -- would probably generate a global financial crisis, much like the one in 2008.
Banks are so intertwined through assets such as loans, leases and derivatives that a shock in Europe would be felt around the world. Twenty-three percent of U.S. banks’ total foreign exposure is in the euro area. That figure rises to almost 41 percent if the U.K. is included. European banks are in greater danger still because of their heavy ownership of the sovereign debt of troubled euro-area countries.
Of course, a U.S. recession would be a major shock to bullish investors, especially because so many believe the economy is on the mend. Yet if the basic economy is as weak as I believe, it won’t take much to push it into recessionary territory.
Newly enacted tax increases are estimated to reduce real GDP by 1.5 percentage points in 2013. That’s less than the 2.9 percentage-point reduction the bipartisan Congressional Budget office estimates would have occurred if Congress hadn’t reached a compromise and taxes had gone up for everyone as spending cuts took effect Jan. 1. Still, the cut in growth is substantial, especially in a fragile economy.
A U.S. recession, though it would probably be moderate, would be a sufficient shock to close the grand disconnect between the reality of weak global economies and the false security created by immense central-bank liquidity. The U.S. would then join Japan, the U.K. and the euro area in a recession. If this were coupled with a hard landing in China, we would face a global recession. In that event, my investment themes for 2013 would shift to a “risk-off” stance.
In such an environment, Treasury bonds would soar because of sparse global demand for credit; their appeal as a haven; and growing fears of deflation. High-quality fixed-income instruments would also benefit as investors sought safety. The dollar would also appreciate against the euro and commodity currencies and would continue to strengthen against the yen.
My list of investments for a “risk off” climate eliminates most of my long-stock suggestions for the current “risk-on” world. That includes dividend-heavy stocks. I still favor natural gas in commodity form.
Medical office buildings should also remain attractive, though as direct investments and not as part of real-estate investment trusts, which appear vulnerable. The same applies to direct ownership of rental apartments. The only long-equity theme I retain is certain types of luxury goods, which may have appeal even in tough times.
The “risk off” environment would be detrimental to stocks, in general, as well as low-quality bonds. With global economic weakness and especially a hard landing in China, most commodity prices would continue to fall.
Once the grand disconnect has been bridged, equities related to big-ticket discretionary consumer spending would be unattractive. This includes automobiles, appliances -- which are hurt by weak housing -- cruise lines, resorts and hotel operators. Consumer lenders are also likely to be unattractive investments as borrowers retrench and repay debt while delinquencies increase.
Some recent upbeat data have been interpreted as a sign that the long housing bust is over. Yet similar optimism prevailed in 2010 when prices rose in response to the tax credits for new homeowners, and that bright spot was short-lived. Until delinquencies are cleaned up and the houses sold, and until excess inventories are liquidated, I will remain skeptical about U.S. housing.
With a further substantial drop in house prices and a related leap in “underwater” mortgages to 40 percent from 24 percent, the equities of homebuilders and related companies would be unattractive, and home prices would be vulnerable. However, this enhances the appeal of direct ownership of rental apartments. And single-family rentals may also be attractive if maintenance costs can be controlled.
If a significant shock occurs later this year, investors will learn the hard way that their neglect of risk in pursuing yield was a big mistake. Junk bonds may be a prime example, even though they rose 16 percent in price last year as their yields dropped and their spreads against Treasuries narrowed.
Investor zeal made refinancing sub-investment-grade securities easy, and defaults were also near record lows. The stampede into junk bonds has pushed the spread between the yield on junk bonds and the earnings yield on stocks close to zero. Earlier refinancings have provided some cushion for low-rated companies in the event of a global recession. Nevertheless, I believe default rates will rise from unsustainably low levels and the prices of junk bonds, leveraged loans and other low-rated securities will retreat.
As with junk bonds, investors rushed into emerging-country debt last year. Both assets are risky, so the similarity of their performance isn’t surprising. They also are similarly vulnerable this year.
Substantial weakness in emerging-market stocks is likely to develop for two reasons. First, a hard landing in China would spread to other developing economies. Second, the deepening recession in Europe and economic decline in the U.S. would be extremely detrimental to export-dependent developing economies.
Falling stock markets in major economies would be the logical consequence of global economic stagnation. I estimate that average operating earnings per share for Standard & Poor’s 500 Index companies would be $80 at annual rates and the price-equity ratio would drop to 13 in the global recessionary climate, about the average for past bear markets. The S&P 500 would then fall more than 30 percent from its recent levels. Other major stock markets should show similar weakness.
My estimate for operating earnings is based on three negative forces. First, a global recession will depress corporate revenue. Second, a strengthening dollar will mean export revenue and foreign earnings of U.S.-based multinationals will be worth less. Third, profit-margin expansion may be over.
Profits’ share of national income recently hit a post-World War II high because of robust cost-cutting. This was needed in the sluggish recovery to boost profits because raising prices was almost impossible and volume increases were limited. Cost-cutting opportunities may be fully exploited, at least for now, and profit margins appear vulnerable.
(A. Gary Shilling is president of A. Gary Shilling & Co. and the author of “The Age of Deleveraging: Investment Strategies for a Decade of Slow Growth and Deflation.” The opinions expressed are his own. This is the last in a five-part series. Read Part 1, Part 2, Part 3 and Part 4.)
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