Some countries escaped the turmoil relatively unscathed – but they won’t be so lucky this next time around as global growth begins to weaken in coming months. That’s because Australia, Canada, New Zealand, Norway and Sweden (an exporter, if not a commodity exporter) are all suffering under the weight of tremendous housing bubbles – each of them worse than the US housing bubble in terms of price appreciation from 2002 levels, according to Saxo Bank.
“When these bubbles pop in a weak global environment, this is likely to serve as a double whammy to these countries.”
Particularly Australia and Canad are at risk, the Danish based investment bank writes in its Q3 outlook. Those currencies are the strongest, and the private indebtedness is as bad, or worse, than it has ever been in the US or the UK. This story could begin to unfold already in Q3 – and there are already signs that Australia’s housing market is turning over. The commodity currency levels could look very different when 2011 rolls around, the Saxo team points out.
Here’s a summary of the report:
Make no mistake, the current PIIGS debt crisis is not contained and the only way to get rid of it is by cutting budget deficits much quicker and much more dramatically than what is being done currently. The German budget cuts are a good start, but they are not enough.
Greek 2-year yields are now trading above 8.6% again, but the equity market seemingly only cares about the next earnings season (beginning in July), which is expected to be strong.
Contrary to the common perception, running big budget deficits kills growth – and that is especially the case in a cash-strapped environment like the one we are currently in. It is perhaps the most distinct feature of this crisis that small and mid-sized companies are almost completely cut off from financing. Yes, corporate bond issuance has been ample until recently, but that is drying out with the lack of risk-willingness and small caps rarely participate in corporate bond markets.
The recent Flow of Funds from the Fed also indicates that the corporate deleveraging of especially financials is almost completely a mirror image of the continued spending by government. The same can be said about Europe. The reckless government spending continues to make GDP figures look “nice” in the short-run but it comes at the cost of long-term growth and it increasingly builds larger imbalances.
The market will have to worry about those larger imbalances and that already happened in the sell-off in May. However, we believe that we will see some optimism linked to the strengthening corporate earnings to be announced in the coming earnings season (beginning in July).
A short-term bounce is risky assets therefore seems likely, but we fear that such a bounce in stocks will only materialize in the creation of the right shoulder in a big head-and-shoulders formation with neckline around 1040. If that is true, the trend in equity prices should be lower well into 2011.
Five Things To Watch Out For
What could cause such a negative drift in equities? We see several factors.
1) A Chinese slow-down looks increasingly likely.
2) Corporate earnings are caused by cost-cutting rather than topline growth and we are thoroughly in the deflationist/disinflationist camp, so we don’t expect inflation and topline growth any time soon.
3) Continued destabilization in PIIGS debt markets demanding a response from the less insolvent E-Z members.
4) Draconian cuts to government spending.
5) Worries about the reset of Alt-A and Option ARM mortgages in the US and a further surge in defaults and delinquencies.
One or more of these factors will impair the earnings outlook of equities in 2011 and 2012 and we believe that they are currently not sufficiently priced-in.
We also maintain our expectation for very low policy rates in the foreseeable future.
The market prices the 1-year Fed tightening at 33 bps. (down from 50 bps. only two weeks ago), but we still believe that is too much. Count on policy rates in the US, UK, E-Z and Switzerland to stay at current levels (or lower) until the end of 2011.
The Saxo Bank Business Cycle Model shows a strong rebound from the bottom in early 2009, but the latest couple of months have indicated some deceleration of economic activity, which in combination with the slowing leading indicators worldwide should be a cause for concern.
US – a letter-soup of stimulus fades away:
With the first half of 2010 drawing to a close, the US economy faces renewed headwinds. Despite the fact that the economy grew an expected 3% annualized in the first six months of the year, we stick to our story for subdued growth in the second half of the year. The tailwinds will fade and the headwinds will grow strong.
Japan – rebound to loose momentum
Japan has perhaps not received as much attention as the US, but its rebound has been just as solid, growing 4.2% year-on-year in 1Q10. We expect further growth, but the pace is likely to decelerate. Net exports have rallied sharply since the trough in early 2009, but the contribution will lessen in the third quarter as a strong JPY weighs on Japanese manufacturers. The toothless EUR may be a tailwind for the Eurozone, but Japan’s export-led growth will be hurt by the currency’s weakness.
Euro zone – EUR scores an own goal, boosts export
Sovereign debt worries have overshadowed everything else in Europe so far this year, but it should not be overlooked that the recovery would have been fragile even in the absence of the current crisis. There is no doubt that too much debt is the fundamental problem for many countries in the Eurozone, but other imminent issues are restricting economic activity.
Just like in the US, the consumer in Europe is still over levered as a result of housing-bubble induced consumption of goods beyond what could be supported without rapid growth in home equity. This will remain a drag on private spending in the third quarter and the very soft labour market is not exactly helping matters.
And for those businesses and consumers that want to borrow, credit is hard to come by as evidenced by the disturbing trends in the various money supply measures; in fact, the broadest measure, M3, is just below naught on a year-to-year basis.
With the half year turn in sight the year so far has played out close to our expectations from the Yearly Outlook. We had a strong start of the year and reached a top in S&P500 at 1217 in April, while we originally expected the level of 1250 to be reached by the end of June. For the second half of the year we continue to expect further hurdles for equity markets which will keep the risk premium higher for an extended period and lead to lower earnings expectations for 2011 and 2012. However there will be bounces in equity markets as earnings are likely to surprise to the upside.
Given our scenario analysis, even if the earnings outlook reflects an economic double dip, then the 12 month forward estimated P/E would end 2011 at 16.5x. Still not high based on what we have seen in the past.
Be careful out there!
Here’s a full copy of Saxo Bank’s outlook for the third quarter of 2010.