Equity markets have risen strongly since early March; bonds have weakened. Now there is a loss of momentum. Is this just a pause in the first phase of a new bull market for stocks… or is it the start of another down-leg in an ongoing bear trend?
Four factors have been driving up share prices:
• The conviction of many, underpinned by the usual optimistic talk by political and financial leaders, that the avalanche of money being created by central banks and governments must succeed. Money supply globally relative to economic growth is now at the highest level it’s been for many decades.
Much of the fear of another great depression that devastated most investment markets last year has evaporated, with most opinion converted to the idea of a normal, even if extreme, business cycle – a great recession.
So now is seen to be the time to buy into growth assets that, with hindsight, will be seen as cheap.
• Short-term interest rates are at record low levels and many financial institutions are flush with cash. Investment bank Goldman Sachs says their cash holdings, earning pitiful levels of interest, are close to an all-time high and twice the level of a year ago, relative to equity market capitalization. This suggests that “weight of money” will continue to drive up share prices as confidence rebuilds.
Much of the abundant cheap money is flowing, not into the intended stimulation of economic activity, but into speculative investments, particularly shares and commodities, just as happened before when the US central bank cut its policy rate to 1%, triggering the boom in real estate.
• The same cheap money, and manipulation of accounting rules to allow US banks to doctor their balance sheets, has dramatically improved the apparent profitability of the financial sector, which remains such an important part of stock markets.
• The strong rebound in the prices of oil and other commodities has encouraged the view that global economic recovery will come through next year, and that it will bring back inflation.
For the moment, equity optimists outweigh the pessimists. Yet many negative factors persist:
• There is no sign yet of the start of economic recovery, despite the cheery talk about green shoots. All we have experienced so far is a dead cat bounce in the first quarter as the fierce inventory-cutting of late 2008 came to an end.
In the US, property prices are falling and seem certain to continue doing so as interest rates on mortgage loans continue to rise – the average rate on a new 30-year home loan surged to 5.57% earlier this month.
The shift towards personal debt reduction, the impact of rising unemployment on consumer incomes, and the hidden “tax” of higher oil prices, bear down on consumption demand.
The stimulus plan is inadequate to the task of offsetting that fall in demand, partly because it was badly designed by Congress in the first place primarily to meet political instead of economic-growth objectives.
Worldwide, economies plunged into crisis
Things are no better elsewhere. Exports of China, Japan, Germany and other economies dependent on foreign markets continue to fall, industrial output is contracting and unemployment is rising.
• No new stimulus plans are being planned and implemented to combat economic weakness in 2010/11. Wolfgang Münchau of Eurointelligence argues: “Instead of solving the problems to generate a recovery, the political strategies have consisted of waiting for a recovery to solve the problem.
“The Europeans are relying on the Americans to generate growth. The Americans are relying on the Chinese, who in turn are waiting for the rest of the world.”
• Although central bank intervention has saved the financial system from seizure, relatively little has been done to write off bad debts and recapitalize the banks – because the scale of the problem is so enormous.
The stress tests of the US banks looked suspiciously positive, while in Europe the authorities appear too frightened to publish any. That’s because the German banks alone are holding largely fictitious assets equivalent to about one-third of gross domestic product.
There is worse to come. The European Central Bank estimates that Eurozone banks face twice as much damage from defaults on commercial and personal loans as they do from write-offs of securities.
Policy focus remains on keeping zombie giants alive, instead of feeding credit into the stricken war zone – small and midsized business. The big banks are concerned with their own survival rather than the survival of the broader economy.
• Much of the time-lagged damage to economic activity still has to come through in the form of bankruptcies, job destruction and personal insolvency. By the end of the year global company default rates are expected to rise to record levels as businesses hanging on by the skin of their teeth are no longer able to do so.
• Little of the essential restructuring, such as switching of the emphasis of economic activity from export to domestic demand in China, or reducing the US’s dependence on imported energy and capital, has been achieved so far. The time-lag is inevitable, but it hangs like a dark cloud over the prospect of global economic recovery.
• The massive restructuring of personal finances (less spending, more saving) that must happen in America has only just begun, while the equivalent radical surgery to Britain’s bloated and unaffordable public sector is the poisoned chalice that awaits its next government.
Everywhere governments are accumulating national debt on an unprecedented scale to finance stimulus plans. Even when economic recovery gets under way, the burden of servicing those accumulated debts must weigh on future growth.
• Governments and investors are awakening to the huge risks inherent in quantitative easing and other money creation measures, with exploding national debts and fiscal deficits.
The suffering public is increasingly angry about the way billions have been given to banksters and other undeserving causes. Having poisoned their well, policymakers know it will be increasingly difficult to mobilize and deploy in future the monetary and fiscal resources necessary to combat contractionary forces.
For the moment there is a lull and everyone waits for something to happen – hopefully some real green shoots of recovery. So equity markets have been drifting upwards, bond markets downwards, the dollar trending weaker in terms of yen, euro, sterling and gold.
Following the strong rally in equities we have seen since October (in emerging markets) and since March (in developed ones), I think it probable that the correction that seems to have started will continue for a while, extending to perhaps 10 to 20% off recent peaks in the major bourses.
That would take the US benchmark index, the S&P 500, down into the 750-850 range. That should provide some attractive buying opportunities for both traders and long-term investors.
It will probably be accompanied by significant weakness in gold and other commodities, but with some strength in long-term bonds and in the dollar.
When equity markets rebound, they are likely to be led by those that recovered strongest from last year’s troughs – emerging markets and commodities.
I have come around the view my friend, London analyst David Fuller, has been expressing for a while, that we could see significant strength in share and commodity prices, even though the world economy remains very weak.
If he is right about that, and if the driving force is abundant liquidity, we could eventually see the strength in equities spill over into other asset classes – even long-term bonds, if the threat of inflation proves to be a phantom.
We have seen these liquidity-driven markets simultaneously lifting a wide range of asset classes before – although such booms always end in tears if there is no concomitant strength in real economic activity.
Equity market booms don’t always predict economic booms (and vice versa). I fear that this year’s will be another example of false signals.
• This article was written by Martin Spring in On Target, a private newsletter on investment and global strategy. Email
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