Roubini's April 2010 research report conclusion

Great Expectations & Sobering Realities:
From the Great Moderation to Widening Divergences
Macro & Market Views | April 26, 2010

In Conclusion:
Translating global macro themes and performance into global market views…
I. Key global macro themes and performance attributes:
I. Divergences: A year of two halves in the United States, within a multi‐speed global recovery
II. Fiscal retrenchment: Now in the EZ periphery, eventually United Kingdom, Japan, United States
III. G7 reflation: Fed, ECB, BoJ, BoE on hold as far as the eye can see, especially with fiscal retrenchment
IV. EM disinflation: Less dollar pegging, more tightening, stronger currencies
II. Cyclical asset allocation views:
I. Currencies: H1 – a strong dollar and US risky asset markets with a steepening yield curve; H2, EM currencies to rise as reflation persists in the US, EU, Japan, but disinflation takes hold in EM
II. Rates: Yield curve steepening to give way to bull flattening as Fed stays on hold and growth falters; EZ government bonds to see continuing divergence
III. Risky Assets: US high‐grade corporates should outperform equities; global high‐yield at ongoing credit crunch risk, as we expect Greece to remain under pressure
IV. Emerging Markets: Disinflation in H2 implies EM equity underperformance as gradual tightening reduces overheating – underweight; currencies to rise, curves to flatten – overweight
V. Commodities: Continued buoyant range‐trading – neutral
III. Secular views:
I. Global index weights will shift: (Government) Bonds up; equity down. EM up; G10, down
II. Historical home bias/index weights require major portfolio shifts, from G10 to EM
III. Episodic risk aversion implies that portfolios have less risk/tracking error in bonds than in EM

Reflection Series: Niall Ferguson at Carnegie Council

"Chimerica is a fantasy country that I dreamt up a couple of years ago. It's the economy you get when you add together China plus America. Chimerica has been, in many ways, the key to the way in which the world economy has worked in the past ten years," says Niall Ferguson.
This Carnegie Council event took place on November 20, 2008. For the full video, audio, and transcript, go to http://www.cceia.org

ZIRP, Deflation and Elevated Risk

Japan was the pioneer of a zero interest rate policy (ZIRP) after experiencing decade-long bouts with recession. Now, the rest of the developed world has followed.

Since late 2007, the U.S. has cut its benchmark overnight lending rate by 5 percentage points to 0.25 percent. The UK chopped its rate by 5.25 percentage points to 0.50 percent. Switzerland, Canada, Japan all sit at or near zero interest rates. And the Eurozone followed, slowly but surely, whittling rates down from 4.25 percent to 1 percent — and moving its key deposit rates down to near zero.

Even after aggressive rate cuts and other efforts by central banks to pump money into their economies and despite all of the chatter about the Fed’s plans to deal with future inflation … deflation remains the problem, not inflation.

Prices are falling in half of the twenty largest economies in the world!

For instance, as you can see in the chart below, year-over-year prices in the U.S. have fallen the most in 60 years.

Source: Bloomberg

In Germany, deflation has hit for the first time in 22 years. And it doesn’t stop there: Consumer prices in Japan, China, France, Spain, Canada, Switzerland, Ireland, Hong Kong and Singapore are falling.

And just this week: Italy joined the ranks, reporting its first drop in prices since 1959 … Japan reported a continued fall in prices … and the Eurozone recorded its biggest price drop on record.

Many think that the central banks, particularly the Fed, have done too much tinkering with the money supply spigot, consequently setting a date with runaway inflation.

The Fed’s job is not easy: Stimulate growth while keeping inflation in check.

But my question is this: Have central banks done enough with interest rates to stop prices from moving lower and to get economic growth back on track?

Contrary to all of the attention that has been placed on plans for removing monetary stimulus, the popular Taylor rule in economics suggests that interest rates in the U.S. should be much lower … well into negative territory. In fact, Goldman Sachs sees the appropriate level for short-term rates at minus 5.8 percent.

Since official interest rates are already near zero, does that mean the global printing presses will have to continue running? Does this rule imply that we can expect more severe deflation ahead?

During the Great Depression, prices fell for four straight years. For two of those years, prices were down 10 percent. But in the world of fiat currencies, central banks have the ammunition of the printing press to fend off such a nasty downward spiral.

However, with increasing global debt burdens, central banks are also scrutinized under a microscope and face massive political forces that may limit the firing of their ammunition.

This changing dynamic from inflation to deflation in a zero-interest-rate world creates interesting global yield comparisons when adjusted for prices. Of course nominal interest rates in major economies are virtually zero. But when normalized, to adjust for deflation (or inflation for some countries), the real yields paint a very different picture. In fact, in stark contrast to what most might expect, the U.S. and Japan join China and Brazil in having the highest real interest rates among the world’s largest countries.

Source: Bloomberg

And with global investors starved for yield, these countries with relative yield advantages, especially those bolstered with the additional advantage of liquidity and relative safety should attract capital.
Most importantly, their currencies should benefit!