United States: MacroVision 2008: US Contagion Spreads, Europe Recouples, EM Eventually Decouples

Our MacroVision symposium in New York — held annually to identify key macro investment themes and ideas, first with our strategy and economics teams and then with clients — yielded a rich menu last week. The key theme for 2008: Many of the world’s markets and economies will recouple to the US downturn. Paced by declines in Europe, we on the Morgan Stanley macro team see short-term bear markets in both equities and credit in developed economies. But we also see credit as the best house in a risky-asset bad neighborhood. And we now want —albeit carefully and selectively — to buy EM, which has the best chance of decoupling from the US. Investors should not confuse those calls with blind optimism based on a naïve, buy-on-the-dip philosophy. Rather, we want to put a stake in the ground to identify where to look for alpha when the beta dust of the current market meltdown settles.

A bearish MacroVision crowd. Judging by polling results and conversations, our savvy investor clients collectively were less committal, but were a bearish, risk-averse group looking for opportunities. For now, they are hiding in cash and surrogates and a variety of yield curve plays. But longer-term they also like US credit and will put cash to work in other beaten-down sectors and markets.

Not surprisingly in turbulent and largely bear markets, the ideas generated last week in our internal discussions and those with clients included both longs and shorts, and distinguished between near-term and 12-18 month investment horizons. Just like our clients, we remain cautious and hopefully nimble right now. Despite recent price action, risky asset markets in our view aren’t fully priced to a mild US recession, let alone the risk of one that is more severe. The meltdown in global markets, especially in Europe, so far this week challenges the widespread prior belief that decoupling will protect European markets. For Europe, we take the other side of the decoupling view: Longer term we still think US equities, credit, and USD/EUR will outperform. Indeed, Stephen Jen’s ‘Dollar Smile’ seems now to be working (see “The Dollar Smile Is Starting to Work,” January 21, 2008).

Key investment ideas from our clients developed during the sessions echo that sentiment. Specifically:

- US Credit was the favorite asset class among a plurality of clients.

- Equities: Clients and we want to be long infrastructure, EM, and MNCs with exposure to EM consumers. They want to be short cyclicals and Europe.

- Rates: US to underperform European rates; express this view in 5-year maturity sector; and even more steepening in EU yield curves than in the US

- Currencies: Long USD vs. EUR, short GBP, buy pegged (e.g., GCC) currencies.

- Commodities: Long agriculture, short metals.

As a group, we also like several long-short pair trades. Specifically:

- Long investment-grade credit vs. short equities (notional ratio roughly 7:1)

- Long subordinated bank debt for the top 2-3 banks in each of the US, UK, Eurozone and Switzerland. For those directionally bearish, buy this group against shorting a basket of 'also-ran' banks.

- Short sectors/regions that will see second-stage fallout from the financial/household-driven bear market (e.g. Tech hardware, Spain).

- Short DAX, Long S&P 100

EU recouples, EM decouples

As a group, we think the US economy is in recession, that Europe is most vulnerable to spillovers from that downturn, but that many emerging market economies are much less exposed. The debates served up many details. A summary follows.

US Recession: How Deep and How Long? Most MacroVision participants think that a US recession has already started. The key questions hotly debated among the Morgan Stanley macro team and our clients were the likely depth and duration of the recession and whether the rest of the world economy would be able to decouple from that downturn, and to what extent. A narrow majority of clients agrees with the Morgan Stanley US economics team’s mild recession scenario; a combination of past and prospective Fed rate cuts and potentially significant fiscal stimulus will pave the way for a recovery later in 2008 and, more forcefully, next year. Indeed, the Fed’s 75 basis point move this week, coupled with the prospect of more and sooner-than-expected future rate cuts, reinforce that longer-term view. However, downside risks to the outlook still predominate. And a vocal minority expects the recession to be deeper and/or more protracted, arguing that a combination of over-indebted consumers, further sharp declines in home prices, and banking sector stress could lead to a situation of prolonged economic weakness resembling the Japanese experience of the 1990s.

Europerecouples .. Most participants believe that spillovers from the US downturn, a stronger currency, a local credit crunch, and a restrictive ECB will undermine Europe’s economies and markets. Our European team already expects euro area GDP growth to decelerate to a below-consensus 1.6% rate this year, down from 2.6% last year, and UK GDP growth to fall to 1.8%, from 3.0%, based on the mild recession call for the US and the expectation that battered banks will restrict lending to the domestic economy, as also indicated by the ECB’s latest bank lending survey. But many on the Morgan Stanley global macro team and an overwhelming majority of the (largely US-centric) client group expect an even worse outcome. They see Europe as the ‘soft underbelly’ or fulcrum for weakness in the rest of the global economy and think that the ECB is making things worse by focusing on inflation rather than growth. A few brave European investors, who argued the case for a surprisingly resilient Europe, were lonely voices in a vocally bearish MacroVision crowd.

.. while EM decouples. Our emerging market economists and strategists, and many of our clients, feel that contrary to previous downturns, many emerging market economies and, eventually, markets will be able to decouple from those in industrial economies. Decoupling does not mean that EM growth will keep the US out of recession, nor does it mean EM economies and markets are immune from recessions among their customers. It means simply that a US recession won’t likely cripple EM as in the past. It is worth noting that in many EM economies, including large ones like China and Brazil, economic growth even accelerated last year as US growth weakened – a rare example of hard decoupling. Our central forecast for EM growth this year is for soft decoupling, that is a much milder slowdown in EM than in the advanced economies.

That’s because in contrast with the past, many EM economies have reduced their dependence on exports and increased their reliance on domestic demand, they have improved terms of trade, and have reduced leverage. Courtesy of external and fiscal surpluses, many EM economies have latitude for stimulative policies, and collectively they have now become sources of global savings. As a result, many of these countries now enjoy robust endogenous domestic demand growth with strong infrastructure investment outlays, buoyant consumer spending and, relative to the advanced economies, solid banking sectors. In the case of China, our China economist Qing Wang argues that a US recession will help cool an overheated economy and should thus promote more sustainable growth over the medium term.

Alpha opportunities in EM. Clearly, the current downdraft in global equity markets has also affected EM markets. However, our GEM strategist Jonathan Garner has now closed his China underweight based in part on these fundamental arguments, and he argues that the Middle East and Russia are likely to be relative safe havens in a bear market for advanced countries.

Indeed, Jonathan makes a broader point: Most of our clients care a lot about where to allocate within equities. They like EM’s long-term outperformance and still see fertile alpha opportunities in EM. While EM’s beta to the US and Europe remains over one, the alpha above and beyond what S&P and MSCI world offer historically has been around 80 bps per month over the period since 1998. In turn, of course, that higher alpha reflects stronger delivered earnings, the secular rise of the EM consumer, infrastructure themes, and currency gains. And the alpha differentials will ultimately swamp today’s high betas.

Commodities are a bellwether for EM. And they aren’t falling sharply; surely, if the EM decoupling story was wrong, crude oil prices should be $70/bbl and falling. So as Jonathan sees it, the beta effect sideswipes EM now but the alpha drivers will create buying opportunities. That’s especially the case if US equities bottom; note that we have now almost reached the typical level Abhijit Chakrabortti identifies consistent with a "normal" US recession.

The end of US hegemony? Ultimately, EM’s outperformance reflects nothing less than a hegemonic shift away from the US. As an extreme case of such shifts in the past, Jonathan notes that Japan’s bear market did nothing to stop the US bull market of the mid 1990s. Even far less extreme differences in fundamentals (particularly surrounding leverage) could result in EM market performance that continues to diverge from that of the US.

Risks. The current market mayhem underscores our belief that market and economic downside risks have risen. Despite extreme pessimism, therefore, we think global markets are vulnerable for now. That’s partly because market participants may still be too complacent about downside risks to fundamentals. A deep US recession would change the outlook for the global economy and markets; all would be vulnerable and sovereign debt would obviously outperform and commodities would underperform. With growth concerns dominant, most believe that higher inflation is only a temporary risk, and that stagflation seems unlikely. In contrast, aggressive monetary and fiscal policy actions may well promote a rebound in 2009, which is almost certainly not in the price and could spark a resurgence of inflation fears.

By Richard Berner/ Joachim Fels/ and global macro teams
Morgan Stanley
January 23, 2008