High Priests Of Mechanical Monetarism Meet The Unstoppable Bear

Of course, I borrow the term of "high priest of mechanical monetarism" from CLSA's Christopher Wood. This time this term is assigned to Morgan Stanley, as the admired macro hedge fund manager Paul Tudor Jones is wagering that Goldman Sachs and Morgan Stanley got it wrong in declaring the start of an economic recovery.

Morgan Stanley came out with global cross-asset strategies report and declared "The End Of Easing" with ideas on "what to expect as policy makers reverse". Well, they are not so bullish on risky asset classes, as the summary suggests:

Risk assets are in the sweet spot. Investors see looming recovery but policy remains at recession-combating levels. The focus will soon turn to the end of easing and, beyond that, the policy tightening phase.

We expect a below-par recovery. So while easing may soon end, tightening will probably not start until 2010 – well into 2010 for many developed economies. Markets, however, look ahead, and when the focus turns to a prospective tightening, we think investors should:

• Sell equities as the strong relief rally is partly reversed. We expect developed equities to settle into a wide range-trading environment for an extended period. Emerging market equities will likely remain high beta, but we expect medium-term structural outperformance to continue.
• Rotate into late cyclicals and quality defensives. Also expect market performance to increasingly reflect the divergent outlook for domestic growth in various regions.
• Buy forward volatility in rates, and expect still-steep curves. End of easing increases volatility for rates, while the curve is likely to be structurally steeper than in the prior cycle. In equity derivatives, we like positioning this view directly via variance swaps, and directionally via diagonal put spreads.
• Buy EM currencies and reflation laggards (SEK in G10, KRW in EM). Currency markets will focus on fiscal strength and high beta/high rate currencies that have lagged to date.
• Stay long credit, but expect lower returns. The big risk to credit is double-dip, not the end of easing.

But for reasons totally different to unstoppable bear Albert Edwards, the top ranked global strategist at Societe Generale, who warns today: "Prepare for the next leg in the Ice Age journey into deflation".

Edwards is trying to find an explanation on the August conundrum of diverging equity and bond markets:

Investors will continue to be shocked by the robust performance of government bonds in the coming months as core CPI crunches lower despite the economic recovery ... For it is quite clear that it is the recovery phase that takes core CPI to new lows in each cycle.

This is because it is in the recovery phase where the lagged impact of yawning output gaps does its pernicious work to core CPI and companies lower prices in response to the cyclical impact of lower unit labour costs. Hence, while the market focuses on the recovery of volumes as signaled by survey evidence, nominal GDP and consequently nominal revenue growth continue to see lower highs in the recovery and lower lows in the downturn. The bond market has already caught onto this event and yields will continue to decline on a secular basis.

But what about massive supply of government bonds I hear you ask? Won't that drive yields higher? Well it never did in Japan. But let's cast our minds back to the early 1990’s US credit crunch (which seems so minor in retrospect!). What happened then is that US commercial banks bought US Treasuries aggressively at the same time as they contracted lending to the private sector (see chart below). This continued well after the end of recession in early 1991.

Click on chart to enlarge.

I note with interest that Swedish Riksbank recently took its target interest rate negative, in an attempt to force banks to remove surplus reserves and resume lending to the private sector. Of course, no such thing will happen as banks are continuing to buy government paper in unlimited quantities - I note here the recent collapse in UK 1 and 2 year yields to new lows. In the US and elsewhere, where commercial bank exposure to government paper is still close to all-time lows, the unwinding of grotesque over-exposure to bubble sectors like real estate ... will continue to underpin the secular bull market in government bonds.

If Edwards is right, I noted the potential for the change in bank assets ... that is very bullish for operating margins?

Note that both opinions do not bode well for equities?