Themes and Trades for 2012
Look back in anger?
In our outlook for 2011 we highlighted that the level of uncertainty going forward was unusually high. If anything, in retrospect, this proved to be something of an understatement. Our stance was broadly a positive one for fixed income, a better USD story and for equities to look somewhat at risk. Set against the actual outturn for 2011, this was a reasonable set of calls and in particular, our long core short peripheral bias was the star performer. Certainly, when one examines the year on year moves, it is the long end of fixed income curves that has seen the most dramatic change, with currencies close to unmoved and likewise equity indices barely changed in the developed market space. In the commodity space, Gold was the clear winner while the CRB is down marginally on the year.
Themes for 2012
The dominant preoccupation of the markets heading into the close of 2011 remains the European crisis and indeed, this has been the subject that has consumed the vast majority of attention during the past year. Perhaps the key theme in 2011 was that with each summit came the suggestion that it would be the 'final solution', only for the markets to find the plan fell short and once again put pressure on sovereign debt spreads. This evolved in the latter stages of 2011 and even though the scale and scope of the measures announced at the most recent summit were by far the most reaching, the clear message from officials is that this is still a work in progress. This opens the potential for something of a shift in market dynamics in 2012 as rather than this perpetual cycle of summit optimism and post facto disappointment, we could see more a 'roadmap' being laid out as to how the resolution structure will be constructed longer term, in which each step along the way is viewed as merely a milestone towards carving out the future of Europe.
The key issue here is that if the evolution of the crisis is 'morphing' into what is more accepted as a 'process' (rather than a transformational or 'magic bullet' type scenario), then we should see less in the way of spurious expectations of a dramatic risk compression but instead a stabilisation and a slow compression based more on fundamental progress of restructuring peripheral economies and instigating the 'fiscal compact', that has been much vaunted in the latest summit communiqué. This is not to say the process is not fraught with risk, as there is both execution risk from individual nation states blocking the progress towards a form of fiscal union and the risk that the markets accept that policy makers are now getting to grips with the crisis and in turn are finally moving towards a structure that is sustainable in the long term.
At the same time it should be acknowledged that the ECB has a part to play in the crisis resolution even though officials play down this concept. The move to 3 year LTROs should help support the banking sector and to an extent will help support government debt purchases, as banks strive to raise their core capital ratios. However without ongoing intervention in debt markets, we fear policy makers may not be given sufficient time to enact all of the policy measures that have been agreed in recent sessions, and indeed that will still be forthcoming in 2012. Equally it is worth reminding ourselves about the growth outlook for 2012 with Europe looking like it will be in recession as least for H1 of 2012 and likewise inflationary pressure looks likely to subside as 2012 wears on. This is hardly a negative environment for fixed income but has to be put in the context of the prevailing level of current yields. In short we are far below fair value in EU, US and UK yields and it is only after a degree of normalisation that fixed income can really be termed appealing once again.
Our point here is that while the European situation is clearly still very uncertain, in a scenario where one believes that this process of 'negotiation in public' for a solution to the crisis will eventually lead to a comprehensive solution, the risk/reward in terms of trading positions favours a risk-on stance. Clearly the concept of some form of transfer union will be central to this and is as yet absent, but in this context the market path for 2012 could prove to be one in which a gradual acceptance of a credible solution is crafted, thereby lowering the systemic risk currently priced in. First and foremost, this has implications for a lot of the 'safe haven' driven dynamics seen in the second half of 2011. In short, bad for fixed income duration but good for equities and credit spreads.
This 'rosy' assessment of a possible future is something of a pipe dream however, without the help of the ECB and its balance sheet. Indeed, without the leeway of more time, the ability for the market to push yields to unsustainable levels will surely take the system to the precipice once again. Equally it should be remembered that even in the context of the rosy scenario, the structural reforms and adjustment process will limit growth for a considerable period and in turn keep the rate profile lower for yet longer. So it is worth questioning the casual assumption that a resolution to the crisis is Euro positive.
One of the other themes from our visits to clients has been a broadly better expectation for the outlook for the USD. Certainly one cannot look at the rate driver to support this view, given the Fed's commitment to keep rates low into 2013. However with the improvement in US data of late and especially with respect to the housing market data starting to suggest some gradual improvement, it is arguable that the macro prospects for the US in 2012 are somewhat rosier than for Europe and the UK, albeit with the risk that the lack of an extension in the payroll tax cuts does soften the potential trajectory for GDP. Still, in comparative terms, there is a case for the US economy and the USD to perform better than a simple analysis of rate spreads would suggest. Certainly the case for the removal of safe haven support has potentially the biggest negative implication for US yields by comparison to both UK and EU markets.
Certainly one of the clearer trading themes for 2012 seems to be biased towards steeper curves. First there is the monetary policy side of the debate, with the UK still undertaking QE and likely to extend the APF in 2012, the FOMC having committed to keep rates low into the middle of 2013 (and being open to QE3 if the US economy falters, contrary to our expectations) and the ECB having just cut rates once again and providing 3 year LTROs to support liquidity in the banking sector. As such, apart from potential money market considerations pressing Libor-OIS spreads, the short end is pretty much locked in. However, the erosion of safe haven support could allow a mean reversion theme to dominate the long end of yield curves, which face the brunt of supply pressure. The same may not hold true for peripheral yield curves but any normalisation of term structures should directly steepen them. For example we are taking a number of cues from the Japanese curve of the 1990s, whereby the process of mass liquidity provision and capital rebuild in the banking sector tended to leave a steep curve structure as the prevailing condition for the term structure. While this interlinking of the banking sector outlook with the sovereign outlook may not be the best outcome, it should ensure the carry/roll down theme is a dominant force in 2012, especially in peripheral markets, in the context that PSI has effectively been removed as a concept from the European resolution mechanism.
One clear concern which few have is regarding the outlook for commodities, since the 'alternative' sectors have been solid performers through 2011 and have provided a welcome diversification from traditional financial assets. However speculative positioning remains substantial in a number of commodity markets, which, together with the prospects of a slowdown in China and what looks at best a subdued global growth profile in 2012, creates a poor fundamental backdrop. This leaves the risk of some liquidation of speculative holdings in commodities as a key factor in H1 2012. The flip side would be that this could in turn generate some benign dis-inflationary forces. Interestingly while gold was the best performer in 2011 in the 'alternatives' basket, this could be sustained in 2012 rather than reversed, as a result of both long term diversification of reserve assets and the protection against tail risk from a stronger macro outcome and potential inflationary risks.
So overall we think the risk/reward heading into H1 2012 is more risk-on than risk-off, although equally, as we move towards a resolution in the European crisis we should start to see correlations weaken and divergence increase between the relative performance of various asset classes. If there is a risk to this view, it is that fixed income fails to hold its current rich valuations while the equity, credit and spread arenas start to see some gradual re-investment themes. In currency space this may not be a USD negative, but the news flow for Europe will be the main driver for the EUR at least initially, which will otherwise hinder some more constructive elements such as the positive basic balance data and record short positioning, which is vulnerable to reversal. Asian currencies look to be at risk in the face of the softer growth story and potential commodity market pressures, while any form of GBP safe haven support could ebb as the systemic risk perceptions ease though the year. Below we list some of our favourite FX and rates trades for 2012, followed by some quantitative fair value estimations and our technical summary for major asset classes in 2012.
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