Risk 2011

For those that don't know, every year Saxo, a Danish investment bank, publishes a list of ten "outrageous predictions" for the following year. This year's are out and they contain a nasty surprise for Australia. At number 5 is this little doozy:

AUSSIE-STERLING DIVES 25%
The UK returns to the values of the old days; they work harder, they save more, and soon enough a surprisingly strong expansion in 2011 is underway as the austerity-stricken country defies the naysayers. The markets have it in for the UK, giving the wide expectation that the economy slows as Prime Minister Cameron’s cuts work their way through the system. However, the large, narrow cuts will not hinder consumer sentiment and as real savings boost production the economy bounces back in the second half of 2011 to end the year as a growth frontrunner in Europe. Australia, on the other hand, is struggling with a weakening economy as China steps harder on the brakes to stop inflation from getting out of control. Add to this an Australian property market, which is at best in need of restraint and at worst looks like a bubble ready to burst, and we will see a decline of 25% in AUDGBP.

This is one of three risks that this blogger sees for the year ahead. It's the one that's bothering markets just now, preventing rises in Australian equities. It's a fair enough worry but not this blogger's core concern. To understand why we need to back out a little.

For the past couple of years, Australia has been in the sweet spot of two combined global forces. On the one hand, deflation has taken hold of much of the Western world (most importantly in the US) which has led to falling interest rates and quantitative easing. On the other hand, inflation has taken hold of much of the developing world as it seeks to grow swiftly through imported capital, currency pegs, exports and fixed-asset investment.

This has meant two tail winds to the price of Australia's key commodity exports. A weakening $US adding monetary momentum to supply shortages. This unique set of exposures has enabled Australia to so far ride out the deleveraging afflicting other Western nations despite the Great Australian Housing Bubble.

It has also given some small hope that the RBA will be able to manage the growth in the economy in such a way that productive investment can grow up around inflated asset prices rather than they shrink back to the economy's productive capacity.

So the key for Australia next year is do the combined forces of emerging market inflation and Western deflation continue?

This blogger's answer is yes.

On the Chinese inflation story, Michael Pettis is instructive today when discussing credit growth:

The quota hasn’t been set, and may even be set at RMB 8 trillion, but even this number is, I suspect, going to be lower than the reality. It is proving very difficult to keep growth up in China except with massive increases in bank-driven investment, even though this year China got a lot of help from the surge in the trade surplus. Next year I suspect it will be much more difficult to count on a surging trade surplus to generate domestic growth, and consumption is not going to kick in, so we are pretty much left with growing investment if policymakers want to keep growth rates in the 9-10% range, which they almost certainly do.

So we'll see sustained or greater still levels of fixed-investment in China for 2011. And that's before we factor in inflation emanating from US monetary policy and bearing down on China via commodity prices.

Which brings us to the second part of our equation: US deflation. Will Bernanke embark on QEIII?

There is no doubt the US economy is growing on a firmer footing in the last three months. And this blogger thinks it will continue. But is it enough to bring down unemployment and close the output gap that is crucial to preventing further deflation? For an insight into this we turn to Tim Duy:

That said, the recent flow of data does little to convince me that the US economy is set to grow much faster than potential. For the sake of argument, supposed that QE2 does in fact support the economy, pushing growth back up to the 3% range in 2011 and 2012. Sales increases, profits increase, jobs increase, everyone's happy, correct? Probably not. Consider the trajectory of the output gap under such circumstances:



I included the path of the output gap through the 1981 recession cycle, centering both on the begining of the respective recessions. At 3% growth, the output gap will narrow to 4.5% by the end of 2012, 14 quarters after the "end" of the recession. In contrast, in the mid-1980s, it took just 7 quarters to collapse the output gap to just 1%. Perhaps more dramatic is a look back at the employment to population ratio:



The ratio went from 57.1% in January 1983 to 59.9% in June 1984 - just 17 months to return just a notch below the 60% of 1980. The record so far this year? Ten months to get from December 2009's 58.2% to last month's 58.3%.

In short, the US economy did not experience a V-shaped recovery, not even close. And I don't see h ow you get a V-shaped anything at this point. Traditionally, employment would rocket up on the back of inventory correction - which would fuel factory rehires - and housing. But, like in the wake of the 2000 recession, the lost manufacturing jobs appear to be permanent, and housing is...well, that story has been told a thousand times at this juncture.

In this narrative, we simply need dramatically faster growth to relieve the stress on the labor market, not to mention to stave off deflationary pressures. Just a reminder, to ensure we are all on the same page on the latter topic:



If the Fed embraces this narrative - that potential growth is not good enough, that potential output should be the target, all else equal, policymakers will feel to compelled to scale up QE2.

Duy concludes that despite this, quantitative easing is done. This blogger disagrees. When all is said and done, the US Fed has thirty years of easing monetary policy at the first sign of trouble. And with no likelihood of inflation, it has the cover to keep doing it. There is no danger of the Fed raising rates in 2011 and a decent probability of QEIII.

So, with our two big macro themes intact for next year, what are the other two risks to growth mentioned earlier?

The first is that Europe buggers itself up. There do appear to be solutions to the European crisis that can sustain the euro. The partial fiscal integration recommended by Wolfgang Muchau and George Soros looks the best of them. Nonetheless, the Germans seem hell bent on exacting fiscal revenge on the periphery and if they push it too far (perhaps already) then the body politic in the PIGS will overrule its weak leaders and default instead of accepting EU bail-ins. Ireland's looming election looks a test-case in this regard.

If European leaders lose control of the agenda to the people of the periphery then all bets are off. The chaos of a euro being refashioned on the run would be a huge financial shock to the world with consequences large enough to spell the end of this reflation cycle, irrespective of the actions of the ECB.

Again, this blogger can only guess, but in a rational world the EU will bumble its way through the current crisis. Not directly and certainly not without giving markets periodic infarction, but it should get through.

This then is this blog's core scenario for 2011: Two powerful monetary forces building the global reflationary cycle periodically interrupted by politics in Europe.

For Australia, that's not actually a bad situation for equity traders. Volatility around Europe will offer discounted entry points as the bigger cycle grinds higher.

For housing, however, it's not good at all. With a serious correction underway in all capital cities and interest rates firm or rising there is a danger that investors bolt for the door simultaneously.

This blogger does not think it will happen because by and large it reckons Australian housing investors horizons for return are long. Thirty years of uninterrupted housing inflation, massive government support, gigantic moral hazard and room to cut interest rates mean the nation has an unshakable faith in prices rising in the long term. This blogger thinks investors will ride out short and medium term weakness in the mistaken belief that prices will resume their rise. Moreover, strong commodities for 2011 will keep national income strong and most in employment.

Having said all of that, the correction underway is significant because it is driven in part by some new but enduring caution in the community about leverage. For that reason, this blogger can't see rates going much higher in the next twelve months, though not down either.

It should be obvious then that the global and local risks for 2011 all share one characteristic, and it's the same one that has haunted markets since the GFC: Will regulators and policy-makers get the balances right? In the short term this blogger guesses that they probably will.

By doing so, however, they are toying with the greatest of three risks mentioned at the beginning of this post.

As has happened in all business cycles for the past twenty years or so, regulators have erred on the side of caution, providing liquidity on weakness and being late too withdraw it. This cycle looks no different and hence we should give the last word to one of Hyman Minsky's best contemporary analysts, Doug Noland of Prudent Bear:

When I read of Chinese policy moves intended to suppress Credit and financial flows going to speculative endeavors – while actively promoting lending to more productive enterprises and to ensure ongoing economic expansion – I am reminded of the failed course of U.S. monetary management in the latter years of the “Roaring Twenties.” It is the nature of Bubble economies that they become Credit gluttons. Credit growth and financial flows grow increasingly unwieldy – and the greater the inevitable imbalances the greater the overall Credit expansion required to sustain the boom. Efforts to sustain boom-time prosperity – while at the same time attempting to harness asset inflation and suppress increasingly destabilizing speculation – are prone to spectacular failure.

Chinese authorities recognize they have a problem – a serious monetary dilemma compounded and complicated by our QE2. Today’s Politburo statement adds further evidence that more aggressive tightening measures will commence in 2011. Yet the markets have turned numb to such warnings. And I’ll be the first to admit skepticism that the Chinese will administer the necessary harsh medicine. Chinese authorities have waited too long and allowed “terminal” Bubble excess to gain a powerful foothold. With the Fed and ECB kicking the can down the road, the markets can be forgiven for believing that Chinese policymakers will lack the fortitude to truly tighten system Credit and liquidity.

This blogger's best guess is that 2011 will be ok but the stakes for Australia are rising fast. The central and worst risk scenario for us is that China doesn't suppress credit fast enough, or the Fed won't let it. In that event commodities continue an evolution into a new asset class and investment in supply runs unchecked toward some blowoff reckoning with a China bust in the medium term.