2015 Macro Outlook
17 Mile General Write-Up
December 26, 2014
I am a bottoms-up stock picker that keeps a close eye on broad market risk; I’m not a macro forecaster. However, I find it next to impossible to have an obsession with this business and not formulate opinions on “macro”. Since I started this diary, I have found it to be enormously therapeutic to document my thinking, as it provides a release of mental energy that otherwise might find its way into inappropriate financial “bets” and excessive trading (i.e. trading macro instruments such as the TLT and GDX). So while macro forecasting is far outside my circle of competency, I want to begin documenting my macro thoughts on the year ahead in order to A) release mental energy, B) challenge myself and C) document my thinking & conclusions over time.
2015 SUMMARY PROJECTIONS
- The global economic expansion continues in 2015, with four quarters of 2%+ real growth
- The U.S. economy averages 2% to 3% real growth for four quarters
- Global ZIRP continues
- The ECB implements full-blown QE
- The BOJ expands its QE program
- The Fed does not raise rates; opens up to more QE
U.S. Interest Rates
- The 10-Year U.S. Treasury Bond yield declines to between 1% and 1.5%
- The USD remains on an upward trend, but with near- to medium-term consolidation
- General projection is for range-bound price action
- Very unscientific forecast would be for oil to rally to $80 in 1H15 before ending 2015 flat at approximately $60
- Double-digit gains with the potential for panic-buying melt-up
- If we get a panic-buying melt-up, the market ends the year flat
Global Conclusion: With the U.S. economy strong, the UK, Europe-ex. UK, China and Japanese economies positive, global ZIRP firmly in place and global equities near record highs, it is a safe bet that the global economic expansion will continue in 2015.
Downside risks include: Russian recession, inflation and devaluation spilling over into world trade; Chinese hard landing (a perennial risk since 2009…); Emerging Markets economic, fiscal, currency crisis due to Russia, declining commodities and strengthening USD; and a European break-up, banking crisis or outright deflation due to ineffective QE program. While tempting to dismiss these risks as baked in the cake due to their “obvious” nature, like the front-page worthy U.S. subprime crisis in late 2007, “obvious” risks can grow far worse if fostered. With global money flowing extremely freely, the trip-wire for many economic and financial issues, “tight” monetary conditions, is off the table at the present time; and with global central banks strongly on the offensive, likely these “obvious” risks can be contained over the next twelve months.
A less obvious risk is the potential for the USD to truly go parabolic. What effect will this have on global trade and financial flows? Or would it be a large stimulus to the U.S. as import prices fall, thus offsetting more negative global effects such as weakening Emerging Markets capital accounts? I’m not a currency expert, but it’s tough to see what will stop the USD with U.S. economic growth and monetary policy diverging significantly from major economic zones. This view is firmly in consensus, however, as evidenced by USD positioning in the futures market being overwhelming long. While consensus is by definition correct for the majority of an asset’s “move”, anything at any time can reverse a widely-held belief. Look no further than the 2014 rally in U.S. Treasury bonds, 100% against consensus belief and positioning at YE 2013. It is just extremely difficult to analyze how much the U.S. economic/monetary divergence is currently priced into the currency market. And further, as proven by the extreme negative Yen positioning for almost two years, crowd psychology does not always act as an inverse predictor for the currency market. My best guess is that the USD strength will continue, perhaps with some short- to medium-term consolidation.
United States. With service & manufacturing PMIs over 50 and stable, jobless claims low and declining, industrial production growing and intermodal carloads rising, real-time economic indicators point to continued expansion. This view is bolstered by expanding credit creation, easy financial conditions and a Federal Reserve extremely reluctant to tighten too soon. It is worth watching the spillover effects on employment from an oil & gas crisis, as the U.S. shale boom has been a key driver of employment growth.
Europe. Europe is an unmitigated disaster, held together by the mere belief that the ECB will do “whatever it takes” to hold the Eurozone together. The Eurozone banking system is so highly leveraged that the ECB’s implicit backstop of the entire EZ financial system is the only thing maintaining the flow of credit; and without the EZ fiscal authorities graduating from economic kindergarten, the lack of fiscal stimulus and/or a large-scale banking recap will keep the EZ teetering on the edge of recession for years to come.
If capital markets lose confidence in the ECB, the banking sector could implode; thus the downside risk to insufficient action by the ECB in 2015 is huge. Mario Draghi knows this and has a proven record of shock & awe; as such, I believe he will deliver in force in 1Q15. This cannot go on in perpetuity, however, but for the next twelve months I believe the ECB can underwrite positive economic growth.
ROW. The rest of the world – China, Japan, U.K., other Emerging Markets, etc – is a mixed bag with aggregate positive projected growth, but with pretty significant downside risk emanating from China and other Emerging Markets.
Global Conclusion: The world’s major central banks – Fed, ECB, BOJ and BOE – remain firmly in ZIRP mode with a slight potential tightening bias from the U.S. and U.K. Though with low global inflation expectations and downside risks from Emerging Markets, any plans for tightening in 2015 remains a fantasy, in my opinion.
United States. Really every year since the Fed implemented its ZIRP in 2008, the annual prediction has been for the FFR to rise as the Fed begins to “normalize” IRP. With over six years of ZIRP now firmly in place, these predictions are not even as valuable as a stopped clock. 2015 is no different.
Market-based inflation expectations currently sit at levels previously associated with initiation of large-scale asset purchases, or QE. Not only is the Fed not going to raise rates in 2015 – barring a sustained spike in inflation expectations – but it could very likely consider re-engaging its QE program. As the scary-smart Cullen Roche suggests, QE is likely the new primary policy tool, as the economy is too weak to handle historically normal interest rates. Roche believes it is likely the U.S. enters the next recession with ZIRP still in place. With low inflation expectations, a rising USD and downside global risks emanating from Europe and Emerging Markets, I strongly agree with Mr. Roche’s forecast.
Europe. The ECB will implement full blown QE in 1H15. The question is, in what form? Given Mario Draghi’s creativity, likely all forms are on the table. The obvious leading choice is EZ sovereign debt; but given the horrific shape the banking system is in, the ECB would be wise to engage in a back-door recap of the banking system via creation of a U.S.-style Maiden Lane facility.
This is not rocket science. All financial flows must sum to ‘zero’; as such, if the EZ private sector is not allowed to take a loss, and the EZ fiscal authorities refuse to engage in fiscal stimulus, then the ECB is the only entity capable of “releveraging” while the EZ banking system deleverages. At present, the banking system is in a zombie state, and until that state changes the EZ will continue down the path of Japanese stagnation. Draghi knows this. With the political hurdle slowly but surely dropping to more manageable levels, and with inflation expectations plumbing deflationary levels, 2015 could prove to be a turning point akin to the “whatever it takes” moment in 2012.
U.S. INTEREST RATES
Conclusion: The 10-Year U.S. Treasury (UST) yield (2.18% at most recent close) likely continues to fall, closing the gap with German and Japanese 10-year government bonds (~.59% and ~.33% yield, respectively). A relatively strong U.S. economy + a relatively hawkish Federal Reserve creates a perfect storm of demand for the USD and thus USTs, driving yield convergence. A large-scale re-initiation of the Fed’s QE program, a pick-up in EZ/Japanese economic growth or a hawkish change of stance by the ECB/BOJ are risks to this outlook.
It has been fascinating to watch interest rate predictions proven false year after year, with many predictions coming from the best of the best the investment world has to offer. What is the definition of insanity?
Jim Grant has not yet wrapped his mind around the fact that countries that issue debt in their own currency should not be viewed as a household budget. He believes the United States fiscal situation (read: dire) warrants interest rates far higher than where they sit today. Well look no further than Japan to see that fiscal “imprudence” by a sovereign nation has virtually no bearing on interest levels (until hyperinflationary levels of deficit-spending kick in, of course).
If fiscal policies largely do not determine interest rate levels, then surely inflation/economic growth does, right? The UST yield’s most recent closing print was 2.18%. With 10-year inflation expectations at approximately 1.73%, the expected real return on a UST, if held to maturity, is approximately .45%. If a “fair” real return on a UST is the real growth in GDP, and projected 10-year real growth is say 2%, then the market is currently pricing in 18 bps of inflation per annum. Or, if inflation expectations are correct, then the market is pricing in 45 bps of 10-year real economic growth. Neither scenario has a high probability of occurring – thus something more than inflation/real growth must be driving interest rates…
While I would say “at the risk of stating the obvious”, I don’t believe the following point is all that obvious given the continued negativity toward USTs: I believe the combination of the global reach for yield + continued U.S. relative economic strength is the primary driver of an abnormally low UST yield. If you are a German, French, Italian or Japanese investor looking for a nominally risk free instrument in which to place your money, do you keep it in your own currency yielding less than 1%, or do you park it in USTs yielding over 2% with the potential of kicker of an appreciating USD?
The bottom line is this: with 10-year German and Japanese government bonds yielding less than 70 bps, and European & Japanese currency zones under economic & monetary pressure, I believe the 130+ bps gap with the 2.18% UST yield has the potential to become far smaller than the market expects. From a standalone investment perspective that would demand a UST real return of close to 2%, this forecast makes little sense; but from a “carry trade”/capital flows perspective, I believe it is directionally correct for the next twelve months.
Conclusion. Really tough to go against the crowd here – U.S. economic growth is relatively strong, U.S. government bond yields are relatively high and the Federal Reserve is relatively hawkish. With U.S. economic growth showing little sign of slowing, and the gap between U.S. government yields and German/Japanese government bond yields unlikely to close due to rising German/Japanese yields, the onus is on the Fed to halt the USD’s rise, in my opinion. And while I do not believe the Fed will raise the FFR in 2015 and could likely consider re-engaging its QE program as a result of falling inflation expectations, I do not believe the Fed would implement a QE program large enough to halt the USD’s rise in 2015.
Conclusion. As outlined in my recent Thoughts On Oil write-up, in summary I am a long-term bear but a short-term bull.
Commodity investment moves in long cycles in response to pricing. In the late 1990s, after more than a decade of low investment as a result of persistently low commodity prices, the supply/demand equation reached a tipping point that ushered in more than a decade of relatively high commodity prices. Likewise, 10+ years of relatively high commodity prices ushered in a capital investment boom that sought a piece of the temporary economic profit “pie”. While it is often said that “high prices take care of high prices”, really what it is is that human psychology never changes. Because human beings cannot help but extrapolate the good times into perpetuity, enormous amounts of investment capital floods the market during a period of relatively high pricing under the assumption that it will earn an outsized economic return in perpetuity. Of course not only do relatively high prices not remain in perpetuity, they overshoot to a relatively low level as the market is flooded with supply. As in the late 1990s, the commodity industry generally, and the oil market specifically, is staring down an extended period of the inevitable “overshoot”. As such, I believe the price of oil will remain range bound for a frustratingly long period of time, moving violently around its marginal cost of production, which currently sits between $70 and $90 per barrel. Though to be fair, as commodity investment capital leaves the market, there will likely be downward pressure on this marginal cost estimate – a prospect I discussed with NDR via Twitter on 12/22/14 – thus making a “floor” price for oil relatively difficult to ascertain at times.
In the short-term I believe oil’s decline is overdone, as it currently sits below even the low-end of the marginal cost range. And as I like to point out for reference, in less than six months oil has declined (45%+) more than gold – an asset with far less utility than oil – took over two years to decline (~40%). To say the least, the price of oil is oversold.
NDR believes significant downside remains for the price of oil given the inflation-adjusted “fair value” for oil is in the $30 range. They point to the $100 inflation-adjusted peak oil price in 1980 as a sign of how over-extended oil became the last several years; though inelegantly stated, my retort was that today’s marginal cost is far higher than the inflation-adjusted 1980 marginal cost. For example, using Jeremy Grantham’s $15 1998 marginal cost estimate, today’s inflation-adjusted marginal cost is $24 . So at a $100 oil peak in 1980, oil traded for 4.2 times its marginal cost (conservatively assuming of course that marginal cost grew in line with inflation from 1980 to 1998…); whereas at the June 2014 oil peak, oil traded for 1.25 times. I firmly believe commodities in general and oil specifically have entered into a secular bear market; I also believe one cannot look solely at the marginal cost of a commodity to determine its “floor” price; but, I do believe it is irrational to project an inflation-adjusted “fair value” to be less than 50% of marginal cost. At consistent $30 oil, 25% or more (rough guess, likely far too low) of the world’s current production would be uneconomic; and forget about bringing on new production. Financial markets can obviously overshoot – but even if oil does go down to $30, outside of a 2008-style demand shock, I would bet enormous sums the price would not stay in the $30 range for long.
Conclusion. As outlined in the recent 17 Mile November Investment Letter, I employ a “weight of the evidence” approach to market risk management, analyzing the market environment via the “Market Mosaic”. The Market Mosaic is a five-part model comprised of the following components: Economy, Market Model, SPX Price/200dma, SPX 200dma Direction and Monetary conditions. I will not repeat what is outlined in the above-referenced letter, but suffice it to say, the market environment is extremely positive heading into 2015. Lending further support to the current market set-up is that market sentiment (not technically part of the Mosaic, but something I watch closely) remains incredibly “jumpy” every time the market declines even 5%; for a more sustained correction, we need more cockiness out of the “dumb money”.
1987 or 1999? (Unfortunately it is going to look like I am simply regurgitating David Tepper’s recent proclamation to CNBC that 2015 could turn into a 1999-style equity bubble; but I really do not care, as I have had this write-up in the works for the past week.) With a growing U.S. economy, expanding credit markets, an “easy” Fed, a global reach-for-yield and modestly valued U.S. large-caps, I believe the U.S. equity market has likely achieved “Goldilocks” status and is RIPE for a massive panic-buying mania, not unlike the panic-buying melt-ups of 1999 and 1987. Expanded reasoning is as follows:
- The U.S. economy is strong and potentially nearing “escape velocity”.
- Outside of high-yield energy bonds, credit markets are wide open and commercial loan books are expanding.
- U.S. monetary policy remains extremely easy; and with inflation expectations at levels previously associated with QE program initiations, not only will the Fed delay raising rates, it could very well consider another round of QE.
- The combination of global ZIRP, Japanese QE and soon-to-be-implemented European QE is creating a monstrous global reach-for-yield.
- U.S. large-cap companies are large, liquid, cash-rich and selling at reasonable forward multiples, making them an attractive destination for foreign capital.
With the U.S. equity market less than six years into a secular bull market and a business cycle still in the middle innings, a 2015 panic-buying melt-up would more likely resemble 1987 than 1999. Why is the distinction relevant? 1999 ushered in a decade long secular bear market, whereas 1987 foreshadowed the large returns to be had over the following decade+…
Forecasting an equity market melt-up is not the point here; I am simply pointing out the upside risks to the current market set-up.