The battle for the future of the global financial system has commenced. The two opposing forces: global liquidity and debt deleveraging, are on the battlefield. The supporting cast: QE3, ECB rate cuts, Chinese stimulus on the one side and EU credit crunch, US fiscal drag, Chinese political inertia on the other, are lined up. After months of skirmishing, the decisive battle appears to be at hand.
Financial markets have responded accordingly, alternating between brutal sell offs and spectacular rallies, almost on a monthly, if not weekly, basis. Investors, frustrated by the toxic combination of high volatility and correlation and in thrall to political intervention, continue to reduce exposure. Amidst all the volatility, global financial asset prices remain range bound, caught in effect between the two opposing forces. However, it is hard not to conclude that the global economic backdrop has grown materially worse.
What will sound the clarion call to the decisive battle? One can imagine waking in the next days or weeks to a press conference with German Chancellor Merkel and ECB head Draghi confirming reports of a fiscal union backstopped by an ECB pledge to reduce rates to zero, act as a lender (or sovereign bond buyer) of last resort and cap Euro area sovereign yields at 5%. Such a scenario would likely include the US Fed engaging in QE3 while China and other emerging economies pledge their support. Recent coordinated Central Bank action to cut the interest rate on USD swap lines may be seen as a prelude to such activity.
How are markets likely to respond to such news? The 4% global equity market reaction to the swap line news and the contrasting muted action in the credit, currency and commodity markets may provide a foreshadowing. But what if all this is a mere sideshow and not the decisive battle - what if the real issue is the reversal of the long standing trend to the globalization of finance?
Earlier work has highlighted (see 2012 Global Search for Yield) the three main risk factors facing investors: the EU debt crisis and its resolution, the OECD growth slowdown and knock on effect on corporate earnings and stagflation in the emerging economies. It is time to bundle these three under the rubric of liquidity evaporation, credit withdrawal and the rising risk of a full-scale reversal of the financial sector trend to globalization which itself has been the spearhead of globalization writ large.
How would this occur? To begin, the crisis strategy employed by the European political class has led to a loss of confidence and trust in the European bond and banking sectors. The possibility exists that liquidity provision by Governments and Central Banks may not be leveraged by follow on private sector investment but instead used to further de risk bank and investor portfolios. The credit crunch in Europe may well be at its very beginning and that much as a desert rain quickly evaporates, leaving little trace, liquidity and credit may continue to drain away. Current examples abound: European banks pull back to domestic markets, Governments order banks to reduce exposure to emerging economies, US money market funds pull back from European banks, to name just a few. The global tide of liquidity and credit, the wellspring of globalization, has turned.
Europe is the epicenter but linkages extend to the US and emerging economies and to those users of leverage ranging from hedge funds & private equity funds to investment and commercial banks themselves. Traders are fired, credit lines cut, trading floors shrunk and additional collateral required. Linkages extend to small and medium sized businesses, to individual consumers of credit, to entire economies.
Globalization has been led by financial services; the reversal of this tide creates deep questions not just about the future of the global financial services industry but the direction of medium term financial asset prices, the prospects for European integration, the political battle between austerity and growth policies and the hoped for rebalancing between Western and emerging economy demand.
How does one invest in the face of such prospects? Bulletproof the portfolio, ignore the volatility, identify opportunities and determine the time to invest remains the mantra. There may well be room for a trade when, and it is when not if, the Merkel - Draghi press conference is held.
Trading such a rally represents a tactical decision; the strategic decision will be to determine the 2nd derivative effects on the real economy and in particular, corporate earnings. The withdrawal of credit and evaporation of liquidity, should it take the direction suggested above, implies a 2012-2014 framework of very deep recession in Europe, US recession, emerging economy stagflation, and the very real prospect of OECD deflation. Deflation coupled with debt overhangs at the sovereign, bank and individual level could see the Great Recession morph into a true depression. Buying the S&P at 1200 or 1100 and perhaps even at 1000 might not seem like the right move in such an environment.
There are always two sides however & it pays to recall the other side as well - the side of record US corporate cash balances and cashed up investors large and small, the side of US and European pensions and endowments challenged by record underfunding levels and 8% return targets. Where does that money go; does it sit in cash or is it put to work?
Performance pressure suggests some of it will be put to work as the evaporation of liquidity may well be a stealthy affair punctuated by periodic liquidity bursts and political cheerleading. For investors, the preferred course of action may be to seek shelter in the US corporate sector, including high yield, in infrastructure projects, in which sovereign wealth funds such as China's CIC are starting to engage, in emerging market USD denominated debt and in the long end of the UST curve.
Time is not our friend - if the EU debacle suggests one thing, it is that delay does not bring more, better options but fewer, poorer ones. Time is running out to avoid a scenario where even the Merkel - Draghi event becomes the last, best sell opportunity rather than the big buy opportunity most see it as today. Getting paid to wait for clarity on how far the global financial tide goes out remains the investment strategy of choice.