Fragile and Unbalanced in 2012

Nouriel Roubini


NEW YORK – The outlook for the global economy in 2012 is clear, but it isn’t pretty: recession in Europe, anemic growth at best in the United States, and a sharp slowdown in China and in most emerging-market economies. Asian economies are exposed to China. Latin America is exposed to lower commodity prices (as both China and the advanced economies slow). Central and Eastern Europe are exposed to the eurozone. And turmoil in the Middle East is causing serious economic risks – both there and elsewhere – as geopolitical risk remains high and thus high oil prices will constrain global growth.

At this point, a eurozone recession is certain. While its depth and length cannot be predicted, a continued credit crunch, sovereign-debt problems, lack of competitiveness, and fiscal austerity imply a serious downturn.

The USgrowing at a snail’s pace since 2010faces considerable downside risks from the eurozone crisis. It must also contend with significant fiscal drag, ongoing deleveraging in the household sector (amid weak job creation, stagnant incomes, and persistent downward pressure on real estate and financial wealth), rising inequality, and political gridlock.

Elsewhere among the major advanced economies, the United Kingdom is double dipping, as front-loaded fiscal consolidation and eurozone exposure undermine growth. In Japan, the post-earthquake recovery will fizzle out as weak governments fail to implement structural reforms.

Meanwhile, flaws in China’s growth model are becoming obvious. Falling property prices are starting a chain reaction that will have a negative effect on developers, investment, and government revenue.

The construction boom is starting to stall, just as net exports have become a drag on growth, owing to weakening US and especially eurozone demand. Having sought to cool the property market by reining in runaway prices, Chinese leaders will be hard put to restart growth.

They are not alone. On the policy side, the US, Europe, and Japan, too, have been postponing the serious economic, fiscal, and financial reforms that are needed to restore sustainable and balanced growth.

Private- and public-sector deleveraging in the advanced economies has barely begun, with balance sheets of households, banks and financial institutions, and local and central governments still strained. Only the high-grade corporate sector has improved. But, with so many persistent tail risks and global uncertainties weighing on final demand, and with excess capacity remaining high, owing to past over-investment in real estate in many countries and China’s surge in manufacturing investment in recent years, these companies’ capital spending and hiring have remained muted.

Rising inequality – owing partly to job-slashing corporate restructuring – is reducing aggregate demand further, because households, poorer individuals, and labor-income earners have a higher marginal propensity to spend than corporations, richer households, and capital-income earners. Moreover, as inequality fuels popular protest around the world, social and political instability could pose an additional risk to economic performance.

At the same time, key current-account imbalances – between the US and China (and other emerging-market economies), and within the eurozone between the core and the periphery – remain large. Orderly adjustment requires lower domestic demand in over-spending countries with large current-account deficits and lower trade surpluses in over-saving countries via nominal and real currency appreciation. To maintain growth, over-spending countries need nominal and real depreciation to improve trade balances, while surplus countries need to boost domestic demand, especially consumption.

But this adjustment of relative prices via currency movements is stalled, because surplus countries are resisting exchange-rate appreciation in favor of imposing recessionary deflation on deficit countries. The ensuing currency battles are being fought on several fronts: foreign-exchange intervention, quantitative easing, and capital controls on inflows. And, with global growth weakening further in 2012, those battles could escalate into trade wars.

Finally, policymakers are running out of options. Currency devaluation is a zero-sum game, because not all countries can depreciate and improve net exports at the same time. Monetary policy will be eased as inflation becomes a non-issue in advanced economies (and a lesser issue in emerging markets). But monetary policy is increasingly ineffective in advanced economies, where the problems stem from insolvency – and thus creditworthiness – rather than liquidity.

Meanwhile, fiscal policy is constrained by the rise of deficits and debts, bond vigilantes, and new fiscal rules in Europe. Backstopping and bailing out financial institutions is politically unpopular, while near-insolvent governments don’t have the money to do so. And, politically, the promise of the G-20 has given way to the reality of the G-0: weak governments find it increasingly difficult to implement international policy coordination, as the worldviews, goals, and interests of advanced economies and emerging markets come into conflict.

As a result, dealing with stock imbalances – the large debts of households, financial institutions, and governments – by papering over solvency problems with financing and liquidity may eventually give way to painful and possibly disorderly restructurings. Likewise, addressing weak competitiveness and current-account imbalances requires currency adjustments that may eventually lead some members to exit the eurozone.

Restoring robust growth is difficult enough without the ever-present specter of deleveraging and a severe shortage of policy ammunition. But that is the challenge that a fragile and unbalanced global economy faces in 2012. To paraphrase Bette Davis in All About Eve, “Fasten your seatbelts, it’s going to be a bumpy year!”

Nouriel Roubini is Chairman of Roubini Global Economics and professor at the Stern School of Business, New York University. His detailed 2012 global growth outlook is available at

Copyright: Project Syndicate, 2011.

Gold Sells Off Sharply, But Long-Term Fundamental Thesis Has Not Changed

by: Eric Parnell

December 15, 2011

The market has been bleeding gold this week.

It was just last Friday when the gold trade seemed to stand on steady ground. While certainly down from its late summer highs, gold (GLD, IAU, PHYS) remained fully engaged in a renewed uptrend that had gotten underway back in late September. And by the end of last week, it was comfortably nestled on its 50-day moving average.
click to enlarge

But then the current week began, and suddenly the lights went out for gold. On Monday, it plunged to support at its 150-day moving average. By Tuesday, it broke this support and closed below the 150-day M.A. for the first time since January 2009. And then Wednesday, gold sliced through another support level at its 200-day moving average. In just three trading days, gold lost -8% and helped usher out the gold bears in full force.

An important question must be asked following the dramatic events for gold over the last few days. Is the bull market in gold finally over?

I’ve owned gold for a long time. One of the first things I've always known about owning gold is that sharp sell offs like these come with the territory. Such are the risks associated with owning gold. And my reasons for owning gold stretch beyond simply trying to capitalize on price gains the yellow metal, as it also serves as an important portfolio hedge within a broader asset allocation strategy. But the fact that gold cut like a hot butter knife through several critical support levels in a matter of days must be respected, as it suggests the potential for much further downside in the days and weeks ahead.

With this in mind, my initial step is to revisit the fundamental reasons for why I own gold in the first place. More specifically, I want to determine whether some event has occurred in the last three days that has permanently altered my long-term thesis for owning gold. I previously presented these situations in a previous article posted back in late August.

First, have we seen a decisive shift to a strong dollar policy in the United States? The answer here is NO. Sure, the U.S. dollar (UUP) has strengthened meaningfully in recent days, but this has not been due to some major U.S. policy change. Instead, it has been driven by European banks scrambling to fund U.S. dollar liquidity needs.
Second, have we seen a shift toward greater fiscal and monetary prudence? The answer once again is NO. Sure, fiscal spending largesse is fading and the emphasis on austerity is building, but governments worldwide continue to struggle with actually enacting spending cuts in any meaningful way. And its not as though some fiscal policy announcement came out in the last three days that would justify the recent price plunge. Much more importantly, the potential is as high as ever for yet another massive round of quantitative easing to try and rescue the global economy from the building European crisis. So the answer here would be not only NO, but instead quite the opposite.

Third, are we suddenly entering a period of steady economic growth and price stability? That would be an unequivocal NO. Sure, U.S. economic data has shown signs of modest improvement in recent months, but a long and choppy road still lies ahead. And the mounting problems in Europe threaten to plunge the global economy into a disinflationary if not deflationary recession. Needless to say, this is certainly not the backdrop where investors are suddenly brimming with confidence about the outlook.

Thus, nothing has occurred particularly over the last three days that has changed my gold thesis. Instead, recent events out of Europe would add to my conviction for owning gold. More pointedly, if we see the collapse of a major global currency in the euro, investors will likely be fleeing desparately to safe haven stores of value such as gold. So what gives?

The answer resides with the short-term effects that can often lead to sharp sell-offs in gold that were also outlined in my previous article from late August.

Have we seen an increase in margin requirements from the exchanges? NO, but the possibility that one might soon be in the offing can never be ruled out. So while this possibility shouldn’t be completely dismissed, this is not likely the reason for the sell off.

Are we currently witnessing a major liquidity event? ABSOLUTELY. For one, major financial institutions, particularly many across Europe, have been selling gold aggressively in recent days in an effort to accumulate U.S. dollars. At the same time, a number of hedge funds have also been apparently working to unload gold positions as they wind down operations before the end of the year. And when the supply being dumped into the market by eager sellers exceeds the demand from buyers inclined to stand back and allow the liquidation to play out, this will result in a sharp decline in price. And such are primary forces behind the sell off in gold this week.

Such sharp sell offs in gold or any other asset certainly should not be ignored. And we may see further sharp declines in the gold price in the days ahead as the liquidation process plays itself out. But given the backdrop that the fundamental thesis for gold has not changed and if anything it has strengthened, such liquidation fueled corrections can provide exceptional opportunities to step in and buy gold. For once the liquidation activity has been completed, the subsequent rallies in gold have been equally explosive with the yellow metal often quickly returning to previous price levels if not beyond.

Therefore, patience with the gold trade may be rewarded in the end. Those holding gold will likely be best served by maintaining positions, as the long-term fundamental thesis has not changed and one almost never wants to stand along side those that are forced to sell into a panicked market with a dearth of buyers. And for those that have been seeking to initiate or accumulate gold positions, the recent plunge may soon provide the long awaited buying opportunity. So while managing the gold trade may become increasingly uncomfortable in the short-term, staying cool and showing patience may be rewarded once the dust settles.

Disclosure: I am long GLD.

December 15, 2011 8:07 pm

US Treasuries: Surprisingly sturdy

Strong demand has brought Treasury bonds a banner year
US treasury building from dollar bill

Back in February, traders on the floor of Royal Bank of Scotland in Connecticut gasped in shock at their screens. What had been expected to be a difficult sale of US government debt instead attracted record demand, led by foreign investors.

The strength of buyer appetite in that $24bn auction of 10-year Treasury paper produced a result that many would ignore to their great cost. As 2011 draws to a close, one thing is becoming clear: against a backdrop of an escalating crisis in the eurozone and lacklustre American growth, buying boring US government bonds has been the right call for investors in search of a safe haven.

The strong performance of Treasury debt this year, with gains of 30 per cent for owners of long-term bonds alone, has left plenty of smart investors with egg on their faces. While there were a host of perfectly sound reasons to start 2011 with a negative view on the bond market, the relentless decline in Treasury yields and rise in prices has compelled many to reverse course and become buyers.
This week demonstrated again just how far the consensus has moved since the start of the year. Investor appetite was strong for the sale of $13bn in 30-year bonds at a modern-era low of 2.925 per cent. Demand for an auction of 10-year notes at 2.02 per cent was the second highest on record after the benchmark was sold at a yield of 3.665 per cent in February.

The continuing clamour for Treasuries comes amid a bruising year for many other assets, with US and European equities in negative territory and sharp falls in commodity prices.

What troubles investors and policymakers is the growing concern that low US bond yields and the poor performance of equities reflect how the world’s largest economy is struggling to overcome the bursting of the credit and mortgage bubble. Debt-strapped consumers and a fragile banking system raise disturbing parallels with Japan, whose economy has stagnated for two decades since its property bubble popped in the early 1990s.

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Although 10-year yields in the US are currently below 2 per cent, the comparable Japanese benchmark resides at below 1 per cent, offering a gloomy suggestion of what may await the US should the world’s biggest economy and housing market fail to overcome its debt overhang. Indeed, the US Federal Reserve this week affirmed it would keep overnight interest rates anchored near zero until the middle of 2013.

Many investors did not understand the situation the US and Europe faced at the start of the year,” says Richard Cookson, chief investment officer at Citi Private Bank. “We are in a Japan-style situation, where the private sector is saving.”

For investors who at the start of the year failed to see the parallels between Japan’s earlier experience and that of the US since 2008, and believe Treasury yields are too low, a bigger concern looms. Fiscal austerity is fashionable in Washington and the lack of government stimulus could limit the recovery of the economy in 2012 and maintain Treasury yields near record low levels for some time.

Mr Cookson, who advised wealthy investors to be heavily exposed to Treasuries at the start of 2011, says his call went strongly against the investing crowd, which believed Treasury yields had seen their bottom. They were seeking better returns from equities.

A February survey of fund managers by Bank of America Merrill Lynch found that more than two-thirds of the 188 global asset managers polled were overweight in global equities, the highest level since the survey started in 2001. Close to the same proportion were underweight in bonds.

The fear, particularly in the US, was that once the Fed completed its purchase of Treasuries in June via its second round of quantitative easing – so-called QE2 yields would rise sharply as the largest buyer in the bond market moved to the sidelines. In bond investing, yields and prices move in corresponding opposite directions. The escalation of the US deficit since the onset of the financial crisis and political wrangling over how to address long-term pension and health obligations were also causing some to question the wisdom of owning Treasuries at low yields.

. . .

One of the most influential bond market figures had already made up his mind. Unknown to investors at the time, Bill Gross of Pimco was liquidating exposure to US government paper in his $240bn Return Fund, the largest individual bond fund in the world. When that action became public in March, it served only to affirm the consensus view that US government bonds were set for a poor year in 2011.

Explaining his stance, Mr Gross told investors that with most of the $9,000bn in publicly-issued Treasury notes in the hands of foreign sovereign investors or the Fed, “the legitimate corollary question is – who will buy Treasuries when the Fed doesn’t?” Mr Gross was also concerned that inflation, which erodes the fixed payments received as interest on bonds, would soon rise and spark the selling of Treasuries; investors would demand a higher return to compensate for that risk.

The judgment appeared plausible at the time as investors fixated on the potential for trouble in Washington over raising the nation’s debt ceiling. That protracted debate incurred the displeasure of rating agencies already alarmed at the long-term consequences of high federal borrowing.

Yet, even against that gloomy backdrop, Treasuries still found willing buyers. It was a trend that soon tested the bearish market consensus, particularly as economic recovery proved feeble. Jeffrey Gundlach of Doubleline Capital, this year’s best performing bond manager, says that the “major mistake most investors made over the past 12 months” was to assume that the rundown in stimulus spending, the ending of QE2 and the fallout from the debt ceiling impasse would be negative for Treasuries.

Citi’s Mr Cookson at the start of the year had no doubt that the US economy was running the risk of mirroring a Japan-style morass of weak post-bubble growth. “The consensus is always wrongequity analysts are far too optimistic and bond guys are far too bearish on their market.”

As early as March, cracks in the consensus that Treasuries were a poor investment became apparent. The Japanese earthquake and tsunami sparked a brief bout of buying in Treasuries, sending yields lower as investors sought a haven in which to park their money. This first test of the consensus view revealed its inherent flaw. Beyond being an investment, US Treasuries are the bedrock of international debt markets. In a world awash with debt, Treasuries are the hub and other market interest rates are the spokes, priced and valued against the US benchmark.

In times of stress, buying Treasuries, German bunds and UK gilts is the safety-first option. As events transpired in 2011, there were times when owning such assets was just about the only action that allowed investors to sleep at night.

. . .

There are two ways to view Treasuries when it comes to investing. One is to focus on the fixed rate of return as income and prospects for future price appreciation. At the start of the year, many investors believed the yields on offer were too low and the potential for further declines was limited.

That, however, ignored Treasury debt’s haven role. When investors flee other markets they park their money in Treasuries, and this characteristic of investment behaviour is why some argue that US government debt should always be part of a portfolio.

Portfolios need to own at least some amount of long-term Treasury bonds, even today at their very low yield levels,” says Mr Gundlach.

Against the backdrop of the eurozone debt crisis, though, there was an argument that the US also faced being held accountable by investors worried about high government spending and rising deficits.

Known as “bond vigilantes”, these investors have in the past sought to hold governments to account by demanding higher interest payments for their borrowing. That occurred in the US in 1993 and ultimately compelled the administration of Bill Clinton to focus on reducing the budget deficit.

But instead of bringing the US to account, the vigilantes have focused on Europe, thus helping boost the appeal of Treasury debt. By August, as investors rushed into bonds even after Standard & Poor’s deprived America of its triple A credit rating, the point was impossible to miss.

At the same time, fading prospects for economic recovery had caused even Mr Gross to abandon the idea that much higher inflation was a greater risk for bond investors. Now, the danger appeared to be sluggish economic growth that over time is followed by lower inflation.

During the summer he would start buying Treasuries again.Do I wish I had more Treasuries? Yeah, that’s pretty obvious,” Mr Gross told the Financial Times in August after he had resumed buying.

Indeed, he has bet on a further fall in interest rates by buying very long-dated government bonds. That began after the Fed announced in September that it would buy long-dated Treasuries in a move known as Operation Twist. It is a strategy designed to lower interest rates for homeowners and companies and thus boost the economy. The return of the Fed as a big buyer of long-term bonds has placed a ceiling on interest rates and helps maintain downward pressure on 30-year bond yields.

In conjunction with its intention not to raise short-term rates from near zero for at least another 18 months, the central bank’s policies are seen acting like a workbench vice, squeezing short and long-term yields closer together at low levels. Against expectations of lacklustre economic growth next year and uncertainty over both the outcome of the eurozone crisis and China’s outlook, it raises the prospect of a Japan-style malaise with low bond yields in 2012.

Mr Cookson doubts the US economy can accelerate in the coming year and reverse the decline in Treasury yields. Low yields are here for some time,” he says. Or as Jack Ablin, chief investment officer at Harris Private Bank, puts it: “The US will be like Japan for the next couple of years due to the contraction in credit and debt overhang.”

This week at RBS, William O’Donnell, who was among those who did a double-take at his screen after the 10-year sale early in the year, says the latest auctions revealjust how much the lack of high-quality assets in the world has pushed safe haven flows into US Treasuries”.

If nothing else, that keeps smiles on the faces of the buyers from early 2011. “If you bought at the February auction you have seen a total annualised return in the vicinity of 25 per cent,” he adds.

Fund managers - a new man at the top

The king is dead, long live the king.

For the past decade there was one voice in the bond market that mattered more than any other investor, write Dan McCrum and Michael Mackenzie. Bill Gross, co-chief investment officer for Pimco, ran the world’s biggest bond fund yet performed like he managed millions of dollars, not hundreds of billions.

Mr Gross was dubbed fixed income manager of the decade by Morningstar, a research group, for consistently ranking in the top tier of bond managers. His $240bn Total Return Fund, Pimco’s flagship investment vehicle, is several times larger than its closest peer and its success has been central to Pimco’s reputation as the asset manager to watch. Mr Gross also gained outsize influence with colourful investment commentaries that brought the dry mathematics of fixed-income investment to life.

Part of the reason why we’ve been successful,” he told the Financial Times in March, was that “we’ve been willing to go on TV. We’ve been willing to write, we’ve been willing to make statements that were somewhat aggressive and controversial.”

Yet this year that strategy misfired. Mr Gross not only missed the trade of the yearbuying US Treasuries – he actively counselled against it. His fund has had its worst run since 1995, producing a return of just 3.5 per cent.

The man who picked up the crown is Jeffrey Gundlach. His DoubleLine Capital runs the first and second placed bond mutual funds in the US this year, according to Morningstar.

Mr Gundlach has long been a contender. A past nominee for Morningstar’s manager of the decade award, he was chief investment officer of TCW, another fund manager, an acrimonious departure in 2009 that ended in the courts.

With fellow refugees from TCW he started DoubleLine, which has become the fastest growing mutual fund in at least two decades, according to Strategic Insight, a research group. From $6.7bn in assets under management at the start of 2011, it is on course to finish the year with $21bn.

Mr Gundlach is adamant that the global economy will remain sluggish. He expects further market dislocation next year thanks to events in Europe.

But the new bond king is not out to build an empire, saying that DoubleLine will likely close to investors when it hits $50bn in assets. “I don’t really want to have 20 offices around the world, 2,000 people,” he says. “I don’t really think it’s any more lucrative than the model that I’m talking about, and it’s just the quality of life.”
Copyright The Financial Times Limited 2011