Political risk is back. What’s really going on and how can you protect your wealth from the fallout? John Stepek and David Stevenson report.
It was going so well. The rally that began in March 2009 seemed unstoppable. Ultra-low interest rates and plenty of public money drove asset prices higher across the world, while most economies staggered out of recession. But in recent months markets have hit trouble. Most indices are down on the year-to-date and China is in a full-blown bear market – the Shanghai Composite index is down 21% since the start of the year. Technical analyst Robin Griffiths, writing for Investment Research of Cambridge, goes so far as to say that “the rally… is now over”.
Meanwhile, investors have piled back into safe havens, such as US Treasuries and gold, which hit new highs in dollars, euros and sterling this week. There are early signs too that banks have stopped trusting each other again (see below), just as happened in 2008.
So what’s spooked the markets? It boils down to two words, says James Surowiecki in The New Yorker: “political risk”. When the credit crunch struck in 2008, investors were glad to have the dead hand of the government interfering in the markets, as long as it was holding plenty of bail-out money. But now, with many countries so heavily indebted they need bail-outs themselves, stimulus packages are turning to austerity schemes and investors are wondering where future growth will come from.
• What the ‘fear gauge’ is saying
• How to hedge your bets
With financial reform being driven more by attempts to impress angry voters than by a genuine desire to improve the way the industry works, the political atmosphere is becoming less investor-friendly. In short, investors are at the mercy of policy-makers who assume they’re making the right decisions for the economy but, judging by their past efforts, there’s slim chance they’ll get it right.
The Greek crisis
Nowhere is that more clear than in Europe. After months of wrangling, the eurozone eventually came up with a €750bn support package for troubled countries, while the European Central Bank was forced to intervene directly and buy government bonds – €16.5bn so far. This week, Greece received its first batch of bail-out money and repaid the original €8.5bn of debt that had raised fears of a liquidity crunch in the first place.
Now, as we’ve noted in recent issues, the main concern over Greece is that it has no chance of repaying its debts in the long run. It’s taken on too much debt. Even if the government manages to push through austerity measures, those will deepen the recession and make it even harder to generate the growth needed to pay back its debts. If one eurozone country defaults, fear could spread across Europe, driving up borrowing costs for other countries, and sending other dominoes toppling. So the €750bn support package hasn’t addressed this concern, it’s merely pushed back the day of reckoning.
This might have bought some time for markets to calm down and a coherent plan to be formulated. Unfortunately though, BaFin, the German financial regulator, threw a spanner in the works by banning short-selling of eurozone government bonds (by writing credit default swaps, which effectively enable investors to bet on bonds falling) and the shares of a number of German banks and insurers. The move sent the euro crashing to fresh four-year lows against the dollar – after all, as Greg Gibbs of Royal Bank of Scotland told Bloomberg, “if you don’t feel you can sell bonds and equities in Europe, you’re left with selling the euro”.
More importantly, BaFin’s actions fed the market’s paranoia. “It makes it look as if the Germans are worried about something behind the scenes that the market’s not aware of,” one pundit told Bloomberg.
Plus there’s a broader problem. Even if countries can balance their budgets by hacking back spending, it hardly adds up to a strong eurozone economy. A weak euro may seem good news for German exporters. After all, it makes their goods cheaper on the world market. But as countries across the eurozone try to force through austerity packages, their consumers will buy less.
Given that Germany exports 60% of its goods to Europe, that can’t be good for the Germans. As German newspaper Die Tageszeitung puts it: “The EU could… be facing a double-dip recession.” That in turn will put more pressure on eurozone cohesion, making nasty surprises from politicians trying to appease disgruntled voters more likely.
China’s house price crash
Of course, no one ever expected Europe to become the world’s new engine of growth. Those hopes have been pinned on China. Indeed, China’s market led global markets and commodities higher during the rally. But there’s trouble here too – China’s economy, driven by a huge stimulus package, has been growing far too quickly for comfort, forcing the authorities to crack down. And the pain is showing in both stock and commodity markets. In April, industrial production was up 17.9% year-on-year. Exports rose by almost 30% in the same period, while imports jumped 52%. This is creating major ‘overheating’ problems. Annual CPI (Consumer Price Index) and PPI (Producer Price Index) inflation are up 2.8% and 6.8% respectively. This is the biggest bounce in combined inflation in 18 months. And property prices, based on a survey of 70 cities, were up 12.8% year-over-year in April, the largest spike since 2005.
So now the government is acting. It’s ordered 78 state-controlled firms to leave the property sector, banks now demand a 50% down-payment on second homes, and 20% deposits are required at land auctions. There are also increasing curbs on loan growth. Reserve requirements for Chinese banks at the central bank have been raised three times since the start of the year – they’re now close to all-time highs. In effect, the government is forcing banks to park more money with it, meaning there’s less cash available for making property loans.
This has certainly hit the housing market. To clear unsold stock, Guangzhou-based Evergrande Real Estate Group has slashed prices in 40 projects in 20 cities by 15%. Other developers have followed suit. Prices in Shanghai, Beijing and Nanjing have been cut by as much as 19%. But the main impact from Chinese tightening is being seen in commodity markets. China is the world’s largest steel-maker and also consumes almost a third of global production. As construction slows, demand for steel and other base metals will ease. Indeed, prices are already falling. Oil prices could also fall further.
Stephen Wyatt in the Australian Financial Review says that if Chinese policy-makers over-tighten, commodity markets could be “crushed”. That would be bad for the few commodity-dependent developed markets that have largely escaped recession, such as Australia and Canada.
It will also be a big disappointment to those who hoped that China would replace the US consumer as the driver of global growth. That’s a problem, because the American consumer isn’t coming back. Unemployment remains high and company profits growth has been driven by cost-cutting, rather than rising sales. As Stephanie Pomboy of MacroMavens tells Bloomberg Businessweek: “The US is in the throes of a secular shift in consumer behaviour.” Pomboy reckons that recent spending growth has been due to tax refunds and unemployment benefits – both of which are temporary. “When the sugar high wears off… it will shock many that we’re not back to 2007’s strong economy.”
How far will markets fall?
Robin Griffiths, who has a pretty good track record on these things, reckons Western markets face a decline of about 20%-25% from their most recent peaks, hitting a low in October, with a likely small mid-summer rally. In the longer run, the West is in a secular bear market that has a while to go. That sounds as reasonable a forecast to us as any other. Griffiths also likes gold, seeing “much higher highs to come” in the longer term, which makes sense, given that paper currencies around the world will be debased as countries compete for export-driven growth.
But with the world a more uncertain place than usual right now, we suspect there will be a great deal of volatility on the way down, with more spasms like the near-1,000-point drop that gripped the Dow Jones earlier this month as investors flick from optimism to gloom and back again in reaction to the latest government measures. So to us, it makes sense to be invested in stocks that are more creditworthy than most governments, and which don’t depend on continued stimulus and economic growth to stay afloat. The good news is that big, high-quality defensive stocks with global franchises are among the few cheap firms left on the market. They may fall back in any correction, but we wouldn’t be in a rush to sell, particularly if you’ve bought these stocks at lower levels for their dividend yields. If you’re keen to protect your portfolio and profit from any potential falls in the meantime, you could try hedging – see the column on the right for more.