A Whisper From London City Gurus

A Whisper In Your Ear From City Gurus

By Ambrose Evans-Pritchard, Telegraph.uk | 16 November 2007

Ambrose has covered world politics and economics for a quarter century, based in Europe, the US, and Latin America. He joined the Telegraph in 1991, serving as Washington correspondent and later Europe correspondent in Brussels. He is now International Business Editor in London.

One of the privileges of writing for the City pages of a major newspaper is that you get a daily diet of wisdom from the shrewdest minds in global finance. Don't ignore those who spend their lives staying one step ahead. So, as a reader service, I would like to pass on a few nuggets that capture the shifting moods in London's Square Mile. I hope to do this on regular basis, perhaps once a week.

Without further let ado, let me hand over to a couple of my favourites, starting with Teun Draaisma, Morgan Stanley's chief of European equities. (It is a Dutch name. A lot of the best analysts in London seem to be Dutch, German, or Scandinavian, and the best hedge fund 'quant' analysts are French, not to leave out the Indians. All the better for Britain that they come here).

Teun called the top on Europe's broader equity markets (MSCI Europe) with perfect precision in June, fearing a nasty mix of widening credit spreads, rising oil, inflation pressures, and extreme over-valuation of small-cap stocks.

He then called the bottom of the August crunch, advising clients to jump back in, believing that this would be a replay of the 1998 global crisis— ie, a mid-cycle correction in a bull market, followed by another year or two of good growth.

This second call has made some good profits for his clients but he has now changed tack, warning that the situation is turning dangerous. Note that he is not advising investors to "short" the market. The final blow-off phases of a late bull market can be a death-trap for premature "shorts". He merely advises caution.

"A growing risk that this decade's bull market is ending. Yes, we have been bullish since Mid-August as we judged valuations attractive, and fundamentals risky but not consistent with recession. We now have serious doubts about fundamental growth due to the deepening ongoing financial crisis and the apparent reluctance of central banks to cut rates as inflationary risks loom. With MSCI Europe still 5.7% above its August trough, we prefer to take profits on our overweight equities stance. "We do not wish to bet against the growth spillover effects of the financial crisis anymore. Will the credit crunch lead to a US recession? This is becoming increasingly likely. Can the rest of the world decouple? We would not count on it. "The risk-reward for equities has deteriorated. We are now overweight cash, neutral equities, and underweight bonds. "We have not seen the usual end of cycle excesses yet (meaning the rush by small investors to buy stocks, and mega mergers) but with the financial crisis not improving we are not so sure any more whether we will get to see those excesses. The end of this cycle may well be more like the last but one (late 1980s), just as a character trait often jumps one generation. That would mean that the equity fizzles out in the next few years. "What is new is the duration of the deepening financial crisis. It is still true that our recession-risk indicator suggests a mid-cycle slowdown, not a recession, while our earnings growth leading indicator suggests decent growth next year. These indicators do not capture the credit market situation fully, however, and many recessionary indictors are on red. "Some of our tactical signals are at worrying levels— ie, net futures positioning on the NASDAQ (excess optimism)— but the real risk is that the credit crunch will lead to a US recession, which in turn drags down the rest of the world."

Mr Draaisma said a "government-led bail-out or a capital injection into financial institutions" would be a fresh buy signal.

The second note is from Goldman Sachs. It cites the Global Markets daily by Dominic Wilson (though the author rotates). This team is extremely astute. Goldman Sachs managed to make decent profits through the crunch [[Hah! : normxxx]].

"The underlying signals on the economic outlook continue to look soft. Yesterday's Advanced Global Leading Indicator reading for November was further confirmation that the weakness that first appeared in July is basically continuing. We have found over time that our GLI has proved to be a fairly reliable signal of market dynamics. The weakness in the GLI— focused as it is on leading the OECD industrial cycle— is a useful reminder both that it is not just US housing weakness that is a source of vulnerability but the broader industrial picture, both in the US and beyond. "While the Philadelphia Fed (factory index) survey moved a little higher, the expectations component dropped sharply suggesting that all may not be well ahead. So the overall picture continues to be one of increased economic risk. An important shift in the way the market has begun to focus its attention more squarely on cyclically sensitive assets. The latest equity damage— both within the US market and across markets— has had a clear cyclical tilt. And cyclical assets in other markets— copper, AUD/EUR (Australian dollar)— have also seen renewed pressure. We think that cyclical exposure remains dangerous right here. "We think the shift in this direction makes sense and is a shoe that has been waiting to drop. Not only does the industrial picture ahead look softer than the market has traded, it is hard to believe that the sharp upward revision to estimates of banking sector asset losses, now reasonably of the order of $300-400bn in aggregate (and the destruction of nearly $500bn of market capitalization in US and European banks) does not increase the risk to the growth picture. "As Jan Hatzius (US chief economist) described, history suggests that US commercial banks target leverage and that brokers have actually tended to manage their leverage pro-cyclically. This means that asset losses which reduce their capital may potentially lead to very large shifts in their desired asset holdings. Given the roughly 10:1 leverage that these institutions tend to run, simple estimates suggest that a $200 billion asset loss borne by leveraged investors might implicitly lead them to attempt to scale back lending to an extent potentially measured in trillions of dollars."

In case you skipped over that— it was "trillions", not billions.

"Decoupling— risks here too. While the heart of these problems clearly lies in the US, it is also true that neither of these risks (the industrial slowing and the financial/credit problems) is exclusively a US problem. In particular, the UK and Euroland both share these vulnerabilities to varying degrees. So there is potential for a significant deterioration in the US to challenge the notion of 'global decoupling' that has characterized the slowdown so far. "This matters for markets since as we have also noted of late, the assumption of 'decoupling' (unlike 12-18 months ago) is now quite well embedded in asset prices."

I hope you picked up a few insights. Both notes are abridged.

Ignore these boys at your peril.

Normxxx    
______________

The contents of any third-party letters/reports above do not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.

The content of any message or post by normxxx anywhere on this site is not to be construed as constituting market or investment advice. Such is intended for educational purposes only. Individuals should always consult with their own advisors for specific investment advice.