Teun Draaisma has given up. Given up predicting the end of this bear market, that is.
In his latest note, titled ‘Japan Until Further Notice’, the Morgan Stanley strategist says we should all stop trying to guess the next turn of the market and instead focus on how this downturn might end.
To wit, he sees three outcomes – two of which are downright scary:
- Successful policy intervention
- Bankruptices and defaults
- Debt deflation and the passage of time
The first outcome, Draasima sees as implausible.The problem with the successful policy intervention scenario is that we doubt policy action can be successful in a short period of time, especially if much of the policy action focuses on spending more and saving less. It may be that there is just too much debt in the system; that a debt transfer from the private to the public sector is too large and that governments cannot finance it without rising financing costs; that time is the best healer, and that there is no quick fix or magic bullet. Also, with every solution that is presented as a magic bullet that ends up not working, the chance of success of the next magic bullet is lowered, because the crucial element of confidence slowly disappears.Which leaves two and three.The second scenario would results in equities hitting significant new lows.In this equity market scenario à la 1929-32, markets become victim of the realisation that authorities have tried everything to stabilise the situation rather quickly, but in vain, and that at some point there are no policy bullets left. This results in a deepening of the current global synchronous recession. The debt problem reduces through mass bankruptcies or defaults. Thus we may now be what is the equivalent of 1931, in the sense that everyone knows about the bad news, and still markets will go much lower as the crisis deepens and authorities are not in control.As for the third, markets will go to new lows for years to come, much as happened in Japan in the 1990s.
In this debt-deflation scenario, the problem of too much debt is simply too big, and there are no magic policy bullets. Indeed, if we look at the US alone, debt over GDP in 2007 at 340% was much higher than the 185% in 1929, so the debt problem to start with was almost twice as big! At the depth of the Great Depression, US credit market debt-to-GDP had risen to 299% because GDP had fallen and most of the debt was still there, and it took all the way till 1951 before it bottomed at 130%. The presence of too much debt in private and public hands erodes confidence and risk-taking and thus growth and risk appetite will remain in the doldrums for a long time.
Draaisma says he does not know which scenario will play out, but says investors should stick with cash and only buy assets that are already pricing in depression style outcomes, such as investment grade credit.
That said, he reckons there are three signposts worth looking out for on the road to the next bull market.
They are:
- A trough in corporate earnings
- A bottom in US house prices
- When banks start lending again and credit conditions become looser
Until then keep the tin hat on; the third notch on the chin strap should do it.
Related links:
Freed-and-Fear -Depression – FT Alphaville, Long Room
A Surprisingly Hopeful Consensus – FT Alphaville
Why-draaisma-is-saying-buy-buy-buy-buy – FT Alphaville