2015 in bullets

US – From anemic to sluggish to solid

US cycle will be protracted and moderate. Disaster myopia from the Great Recession lingers and its shadow over real-economy risk taking will be slow to fade. Structural issues too will keep growth throttled back.

The chance of recession—even in the face of external shocks—will be low until the real economy is investing, taking more risk.

It’s hard to be strategically bearish US stocks until the output gap is at a minimum closed. Bear markets typically come when cycles turn.

The spectacular oil drop causes dislocations up front, but has a long-tailed payoff if it stays below 75.

Rate scares might trigger corrections and echo taper tantrums, but won’t derail the growth trajectory.

Long-end rates will go higher when the Fed starts to let its book run off, probably late next year. The economy will be in a position to handle it when it happens.

If the yield curve inverts along the way, it may scare some, but it would be technical and transitory, not a sign of impending slowdown/recession.

Fear of stronger dollar is overblown, given closed nature of US economy. But it will weigh on sentiment and to some degree earnings.

Housing will continue to disappoint, as the epicenter of a bubble is always last to work off the excesses. Also, lots of institutional investors saddled with inventory are looking for an exit strategy.

There may be pockets of financial exhuberance but I am not worried about broad-based excesses bringing down the economy for the foreseeable future. Too many people still too fearful of the systemic risk scenario to get the “All Aboard” sentiment necessary for that degree of risk taking.

And too many people ascribe too much of the markets performance over the past few years to the Fed. This keeps many worried and has been a huge positive.

However, there will eventually be financial excesses that do damage. That’s the nature of markets in a financially globalized world. But the real economy underneath has to be vulnerable to that kind of feedback loop, and the froth in the real economy and SIFIs is not yet on the horizon.

Europe – That which is not sustainable will not be sustained

Europe can’t grow. And the hurdle to overcome demography, technological substitution and globalization is high. In the meantime, internal devaluation uber alles.

ECB QE won’t be able to turn the growth dial. QE has lost much of its shock value, sentiment is in a more neutral place relative to when US QE was rolled out, yields in EU are already low, EU banks are still clogged (and EU finance is bank-centric). I don’t even think EU sovereign QE will boost markets much. We have already seen the man behind the curtain.

I do not think structural reforms—desirable though they most certainly are—can be enough even in the abstract to return peripheral countries to the level of productivity necessary to resolve the lack of competitiveness. In practice, of course, far less in the way of structural reforms will be attempted, much less achieved.

A weaker euro won’t help much either; the imbalances are inside the EU. Externally, it is a closed economy, one that mostly exports products whose demand is fairly price inelastic (if you’re buying on price and not quality, you’d already be buying from somewhere else).

This implies that the euro will continue to depreciate, and if it is to make a meaningful contribution to EU GDP, it will have to depreciate a lot, perhaps even below the levels we saw back in 2002. It bears recalling that the trade-weighted euro has depreciated far less than EURUSD.

In the absence of growth, the centrifugal political forces that were set in motion by the crisis will only gain momentum. I expect this to be a drawn out process, but it is what will ultimately lead to a reconfiguration of membership in the single currency.

The timing in my mind is very uncertain. And this is a problem for me. Every time I see a bout of instability in Europe I will ask myself is this THE moment. This will make it hard to hold onto investment positions, because when the man bobbing in the ocean finally goes down for good, you will want to be light on risk.

Emerging Markets – Muddling through, no crisis

The fantastic 10-year run in EM started to unwind in 2012. I expect this has further to go while EM digests the rapid domestic credit expansion that drove its growth phase.

I do not expect a return to the EM crises of yesteryear, even though there may be a country or two that gets itself into policy trouble managing the transition. Unless social unrest breaks out in China (very low probability), I think the far superior initial conditions with which EM countries entered this down cycle will keep systemic EM crisis off the table.

To attract capital back into the EM asset class on a sustainable basis you will need a story with some combination of three things:

  • Weakening dollar,
  • Low/falling US rates, and
  • A compelling growth differential story to convince investors to take that extra risk associated with EM allocations.

We are not there on any of these points—even though there may be a temptation to take a stab at EM in the beginning of the New Year, as the cumulative underperformance there has been enough to attract some mean reverters.

Commodities – Stay away

Very much like EM, commodities had a supercycle run that ended in 2012. With the prospect of rising rates in the US and a strengthening dollar, it’s hard to see when its fortunes might change.

The bottom line is that portfolio demand for commodity allocations will continue to retreat. Investors chase performance in reverse as well. Pension funds will cut back or get out, and commodity funds and specialty products will continue to unwind. Commodity investors just started in 2014 getting used to the notion that the wind is no longer at their backs.

Soft commodities have faster supply responses, so, they may well do fine. But hard commodities and especially precious metals should continue to go lower in dollar terms.

Oil is a bit of a special case, if for no other reason than it has already fallen far and fast. It could well bounce. But the weaker portfolio demand for commodities and the technological substitution that will likely threaten oil long term make a sustained bounce a serious uphill endeavor.

Of course there will be many things that surprise us over the course of the year ahead. And we will have to adjust to them as they develop, but these are the grandes lignes as they appear to me on the eve of the New Year.

Mark

Bologna, Italy

December 23rd 2014