Toxic migration and the bull case

It’s not as fun to be bullish. Bears are smart. Bulls are wide-eyed optimists. Bears have data. Bulls tell stories. Bears make money when everyone else is in pain. Bulls make money when everyone else already claims to be a genius. In short, many of us get more satisfaction being bearish because the psychic payoff is greater: we calibrate our own self esteem not by our victories in absolute terms, but in our victories relative to others.

So, with personal biases disclosed, let me lay out the bullish case. I don’t want to get carried away. For one, I know that if the market goes down in the next five minutes there will be all kinds of snickering from the cheap seats. Bearish calls gone wrong aren’t as easy to ridicule as bullish ones. Plus, we’re at 1400 on the S&P, not 1250. (And, yes, I know the VIX is at 14.)

The serious reason not to get carried away, however, is that world growth is not good. And it is not poised to turn around for a while, I suspect. US growth is anemic, and it feels like an achievement at the moment to be the tallest midget. Europe is in recession and this will persist for the foreseeable future. China is slowing cyclically and downshifting secularly, and China sets the tone for Asia (and, arguably, for emerging markets in toto). Moreover, the developed world is wracked by deleveraging, and the combination of globalization and excessively generous government promises pose potentially lethal structural challenges that we haven’t shown any appetite for addressing.

So, wait, how is any of this bullish? It’s not, but there is a long-term reason and a short-term one that make things less dark. Let me start with a question: Where do you think the S&P would be trading if we could take a European Lehman II off the table? My guess is meaningfully higher. Without financial contagion it becomes much, much harder to push the US into recession. And the fiscal cliff, while a real risk, is likely to be handled differently this time around much for the same reason we in the markets have fairly well discounted it: disaster myopia. We are much more prone to make a new mistake than to repeat our most recent one.

The basis for taking Lehman II off the table is the slow but steady migration of Europe’s toxic assets from the private sector to the official sector. This is a big deal. By the time this is over (and I think it will end by a number of countries leaving the single currency), the overwhelming majority of the bad debt will be in the hands of the EFSF, ESM, ECB, IMF, and in national banks that are de-facto (probably soon to be de-jure) nationalized. With each round of intervention, the private sector sells to the official sector. And the official sector won’t be subject to marginal calls/forced selling when the Schatz hits the fan.

The Lehman bankruptcy had such a nasty impact on markets because at that point in time the toxic assets were in the hands of hedge funds, investment banks, the prop desks of investment banks, and in their hands on a massively leveraged basis. Once the selling started it fed on itself because the funding of those positions got taken away. That’s not going to happen with the official sector holdings of peripheral European debt. With private sector investors much less leveraged and virtually clean of this toxic debt, the contagion impulse from Europe—whenever the dismantling of the euro happens—will be much weaker. Again, I am not suggesting the end of correlation, nor that the contagion impulse will be zero, nor that the economic impact on the defaulting countries won’t be very painful. I am merely saying that it won’t trigger anything close to a repeat of the wholesale portfolio liquidation we saw in 2008. And because many at some deep dark level still fear precisely this kind of repeat, the realization that this is not a realistic scenario will be a positive for risk taking.

The shorter-term consideration is that the recession in Europe and the slowdown in Asia are largely discounted. This wasn’t the case at the beginning of the year. We are finally starting to see the bad European growth numbers come in in line with forecasts, rather than continuing to surprise to the downside as they have for the past 18 months. And in Asia, while people are still hoping against hope that China stimulus will swoop in and save the day, it is become clear that the days of 10 percent growth are over and making the 7.5 percent target the country has set for itself this year will be an achievement. Again, I think there is more slowdown to come in China, and there are still people who will be caught off sides by this. But my unscientific sense is that the market has priced in as much as two thirds of the slowdown we are going to see from China.

The bottom line is that given the growth scenario that the market has been pricing in, the budding recognition that the progressive migration of the system’s toxic assets to official balance sheets will take Lehman II off the table, and the light levels of risk taking amongst the big players (who have been playing not to lose rather than to win) we would need to rekindle financial meltdown risk very hard and soon to send markets down in a sustained and meaningful way.

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