Dubai doesn’t matter. Not by itself at any rate. The troubles of a toytown in the desert are not systemically important, despite the emirate’s efforts to make itself a financial centre. The potential losses would be painful to lenders, but wouldn’t shake the world.
So why are markets hanging on every twist and turn of the saga? Because Dubai is an $80bn reminder that risk has not been abolished. The recovery is not yet safe. Dubai might not matter by itself. But who knows what other traps litter the path?
I don’t think this marks the end of the rally. But a sharp sell-off in the next few months is very likely. Uncertainty is returning to the markets. And that’s something we’re going to have to live with…
The rally is already slowing down
Firstly, the rally has certainly been strong, but we shouldn’t overstate the likely size of a sell-off. To a great extent, the rally’s strength reflects just how scared investors were after Lehman Brothers collapsed, and how oversold markets were.
We can break the rally into two sections. The first, from early in the year until around August, was about markets returning to normal from this state of blind panic. We can see this best by looking at the credit markets. The chart below shows the spread between yields on US government bonds and bonds in the JP Morgan Asia Credit Index.
Figure 1. JP Morgan Asia Credit Index Composite Blended Spread
As you can see, these hit historic highs as investors dumped everything risky for the most conservative and liquid investment around: US Treasuries. Then, as confidence returned, investors bought riskier assets again and the spread narrowed.
By August or so, most markets were back to their pre-Lehman levels. In the case of the MSCI Asia ex-Japan (AxJ) equity benchmark, this was an 80% rise from the lows in less than six months. This happened faster than I expected, but the overall trend is not a surprise.
Figure 2. MSCI Asia ex-Japan Index
Since then, progress has slowed. Investors have switched from buying back into the positions they dumped in the panic, to a more normal process of investment. Sentiment has been bullish as economies emerge from recession, but gains have been much more muted. The AxJ is up 9% since the start of August. This is still a faster pace than we can expect to average in years to come, but it’s a clear slowdown. And the trend seems to be slackening further.
This not a bubble – so don’t expect a bust
There’s been a lot of speculation that this is a new credit-fuelled bubble, inflated by ultra-easy monetary policies in Western central banks. But as I discussed in this short piece, it’s hard to find much evidence to support this. Outstanding credit at US banks is still declining. It’s more likely that we’re simply seeing investors’ appetite for risk return.
In the US, inflows into mutual funds that invest in foreign stocks have been around $25bn since the start of the year, according to Investment Company Institute. Meanwhile, domestic mutual funds have seen net outflows of around $36bn. Both types of funds saw heavy outflows in 2008. In other words, it seems that investors who are getting back into the market are banking on regions like Asia outperforming the West over the next few years.
Still, even now, markets are generally nothing more than fair value again. Overvaluation is mostly a problem in a couple of developed world markets. For example, the S&P500 remains well above fair value on long-term measures such as the cyclically-adjusted price-earnings ratio and the q ratio. But this has been true since the 1990s. It seems increasingly likely that the US market will go through several more years of ups and downs before it’s cheap again.
When we finally get a pullback, it’s very unlikely that it will take us back to the lows we saw earlier this year. I’d certainly like to see a cathartic low this time round to set up a clear bull market. But I don’t think we’re going to get one.
The rally could end in one of three ways
Still, there are at least three obvious risks that could put a substantial dent in the market at some point in the next year. The first is the one that investors seemed to be most concerned about prior to Dubai – tighter monetary policy.
Obviously, this risk is strongest if you believe in the credit bubble argument. But even if markets are not being propelled by cheap money, higher interest rates and a reversal of quantitative easing could have an impact on riskier assets. If short-term rates and government bond yields rise, then these assets start to look more attractive compared to others. Investors will be tempted take the profits they’ve made in the last few months and invest them somewhere safe
I think this risk is overplayed. The chances of Western central banks tightening policy significantly over the next year seem slim. Their economies remain very unhealthy (more on this below) and a Japan-like scenario with ultra-low rates for many years is quite possible.
So I think it’s unlikely that Federal Reserve tightening will suck money out of Asian markets. However, local central banks are likely to begin tightening soon. We can expect hikes in India, Indonesia and Australia (again) in the next couple of months. This could act as a bit of a headwind to some markets.
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All is not well with the world
The second possible trigger for a big sell-off is an event that makes investors question their assumptions that all is well with the world. In other words, we should be watching out for a Dubai-like incident that has more implications for the whole system.
The growing concerns about the state of Greece’s finances are a good example. As a eurozone member, Greece is much more relevant than Dubai. Not least, because there’s an assumption that the major euro economies won’t allow a fellow euro member to default.
Yet in reality, there’s even less reason to assume that this would happen, than there is to believe that Dubai would always bail out its state-controlled companies. And even a hint that Greece might be cut loose would have big implications. Not just for Greece, but for the other developed euro economies with shaky finances: Portugal, Italy, Ireland and Spain.
I also suspect there are underappreciated risks in Latin America, especially Mexico. Appalling drugs-related violence has left a large area of the country lawless, while oil production – vital for the country’s finances – is collapsing. A crisis here looks very likely in the medium term. The chance that it could happen sooner can’t be ignored.
I don’t see any obvious immediate risks like this in Asia. The region’s economies are generally in good shape compared with the rest of the world. But Asian markets certainly wouldn’t escape the fallout.
Can markets shrug off a slowdown?
I reckon the rally is most likely to end due to the third option – a slow realisation that the global economy is still in pretty bad shape. The implosion last winter means year-over-year comparisons are looking pretty good at the moment. But most of the current signs of life are solely the result of government stimulus.
Many Western economies will be weak for years to come. They’re unlikely to experience anything as bad as Japan’s lost decade, which was made worse by other factors such as demographics. But Japan is certainly a blueprint of a sort.
Despite talk of bringing the budget back into balance as soon as possible, I think it’s unlikely that the current round of stimulus will be the last. Years of higher government spending and rising debt look very likely.
If the stimulus wears off at any point, these economies are likely to relapse, and we may see it happen next year. For example, while the Fed is very unlikely to tighten monetary policy soon, US legislators may be very reluctant to vote for more public spending if they see a further increase in debt playing badly with voters.
Any relapse in the West will have global consequences. Asia’s relatively sound domestic economies gave them the base for a decent recovery. But it was the rapid rebound in exports (see chart below) that has allowed many to grow at a double-digit pace in recent months.
Figure 3. Year-on-year change in exports, selected Asian countries
We shouldn’t expect a dip back into recession to be accompanied by the kind of implosion that happened in late 2008. But Asian economies certainly won’t be able to shrug if off entirely – and markets are unlikely to either.
Keep an eye on the dollar
What all three of the above scenarios have in common is that they’re likely to be accompanied by a strong rally in the dollar. US capital markets are still the world’s deepest, while the greenback remains the global reserve currency.
So when investors are keen to take on risk, money flows out of the US into foreign assets and the dollar weakens. When nerves fray, it flows back and the dollar rises. So it may be significant that the dollar index (which measures the value of the dollar against a trade-weighted basket of major currencies) picked up sharply towards the end of last week. That could point to investors deciding to take some profits in riskier assets and return them to something more conservative.
Figure 4. Trade-weighted dollar spot index
So you should definitely keep an eye on the dollar if you’re trying to spot when a wobble could turn into a rout. But it will be of limited help. It’s unlikely to flag an enormous forthcoming sell-off, after which we expect equities to be a one-way bet again, simply because that’s unlikely to happen.
In fact, recent years may have spoiled investors. If you look at the chart below, which shows the volatility of the S&P 500 since 1929, you can see that the period from 2003 to 2007 was extremely calm. Shares were up, up and away with little interruption for four years. (I’m using the S&P here because it has a longer history than any Asian market.)
Figure 5. S&P500 six-month price volatility
However, as the chart shows, that experience wasn’t at all typical over the century. With this relief rally now over, there’s a good chance we’re heading into a more typical era of ups and downs. If we’re fortunate, we may be able to invest more during the downs and lighten up during the ups. But ultimately, patience and a long-term view will be more important than market timing.
That’s the real importance of the Dubai shock. The truth is that it isn’t much of a shock by usual standards. We should see it as the kind of thing that often happens in markets. The world is getting back to normal – it’s just that normal isn’t what many investors think it is. There could be many Dubais in the months and years ahead. We’ll need to put up with them.
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