Plan B

It might be the weather – it’s muggy as hell down here in South London - but I started getting this ominous feeling over lunch. Like something big was going to happen, and I wasn’t ready for it. And the ominous feeling I was getting was this – it feels like we’re going to have an inflationary bust this summer.

Now, to give you a bit of colour on this – there are four major phases of global macro. Deflationary boom, inflationary boom, inflationary bust and deflationary bust. As a macro trader my main job is to work out where we’re at, and where we’re going to. And one reason that I like running global macro money is because you’re moving away from just buying or selling stocks – to playing markets on three or four dimensions. When you catch it right, you can make a bundle with limited risk. Why limited risk? Because some of your trades will likely work, even if your call is off.

Now, to get a disinflationary boom – you need accelerating growth and underutilised resources. 1991-3, and 2003-5 were classic examples. They were the best of years for emerging market stocks, the dollar fell, and credit, real estate and financials tended to outperform. The yield curve was steep.

This decade’s deflationary boom morphed into an inflationary boom on the way into 2006. Growth continued strong, but utilisation got stretched. The Fed raised rates, and gave the markets pause in May and June of that year. After oil fell in August, it set off another brief bout of reflationary boom, that turned into inflationary boom through to mid-2007.

Now what I think we get going into autumn 2008 is an inflationary bust; slowing growth, with high resource utilisation. What happens in an inflationary bust? Stocks go down – in part due to slowing earnings, in part due to derating. Commodities get ragged – with a narrower and narrower leadership. Emerging market stocks get shot. The dollar consolidates after a big fall. Oh, and banks get stuffed. But probably the defining point about an inflationary bust is the yield curve – it flattens hard.

So a few things are playing to this call. Yield curves have indeed been flattening of late, as central banks have got more worried about current inflation, and markets have started to worry about future growth. The rise in commodities has narrowed, with softs and various base metals rolling over while oil has hit new highs. The dollar has been whipping around – basing against the Euro, and rising fast against the Rupee and the Won. And over the past week or so, stocks have stuttered.

So the market is certainly setting up for the move. But what about the macro?

My bet here – we’re about to run into an unpleasant lurch down in developed world macro going into the end of the year. And there are a few reasons to suspect that markets might not be ready for this.

The first is the fact that two shocks are more than double the trouble of one. I owe this insight to James Carrick from Legal & General. Back when oil was rising, but the world economy kept booming – a lot of people would ask us why oil wasn’t causing more trouble. Our answer – because the credit boom was accommodating higher oil prices. US consumers didn’t have to worry about oil doubling over two years. They could extract more than enough capital from their houses to make up for the dent in real income. And what’s more, their nominal incomes were rising fast as well. No need for concern.

But when oil prices double in a year when house prices are down 14% (on the CaseShiller index), and nominal income growth is fading fast – well, then there’s no place to hide.

Likewise, you can live through a credit crunch if you have a proactive central bank and collapsing resources prices – as you did after the Asian crisis in 1998 and after the gulf war going into 1991. But you can’t live through a credit crunch if oil doubles to a real all time high. You’ve got no plan-B.

The next issue is lags. And I’m grateful to Gerard Minack of Morgan Stanley for this one. The lag from a credit crunch can be long. Gerard noted that bank lending standards typically lead investment spending by nine months. And banks only started their tightening in July of last year. So, you’d only expect to see the impact on investment starting around the April data – due out this month. A lot of economists have been surprised by the resilience of the US economy this year – and now expectations of recession have receded sharply. But it seems to me quite likely that the recession call will be right back on the table once the deterioration in US business investment finally shows up in the data this summer.

Third, the tax break. Yes, it’s a monster. Yes – it’s adding large to US growth on an annualised basis right now. But for every percentage point of growth it adds to what would have been below trend growth right now, it will subtract from below trend growth in the autumn. My view – the US enters recession in September.

Fourth – the leading indicators on the UK and Europe have collapsed. And both central banks are determined to quell inflation – which lags growth – before reflating again. They are so far behind the curve, I’m not sure they know where the curve is.

And finally, we are seeing increasing numbers of emerging markets getting shredded – another hallmark of an inflationary bust. It’s the diametric opposite of a deflationary boom. First we saw Iceland, now we have Vietnam. India is looking more and more precarious. And, as I’ve highlighted before, I think the economies of Eastern Europe are in Wil-E-Coyote mode – they have run off the edge of the cliff – but they haven’t looked down yet.

My sense – there will be nowhere to hide this summer. So either close up and go watch Wimbledon. Or – my preferred choice - go very short, and watch Wimbledon on the other screen. I’ve taken my net short to 100%.