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Stock indices have made their verdict quite plain

This article was posted on Aug 3, 2009 and is filed under Stock News

On some occasions markets can themselves cause a vindication of their predictions. Keynes would call it the engagement of animal spirits where
the ebb and flow of human emotion has a sustained and self-perpetuating impact on activity. Sanskrit scholars, who reserve such references for divine miracles, would call such a phenomena ‘Swayambhu’, the self manifested.

On other occasions, of course, the markets can simply be way ahead of facts. I fear now is one such time.

The debate on whether the global recession has been beaten continues in policy circles but stock indices have already made their verdict quite plain. Having bottomed in February, emerging market equities as a whole have retraced about 43% of the peak to trough decline seen over the last three years. Indian equities have considerably bettered the global EM average, and have recaptured 57% of the drop. Caution is in order.

Most of the bullish arguments on today’s market revolve around technical levels, positioning and earnings momentum. Fundamental arguments have been secondary, but to the extent they are used, strong demand from China, improvements in the US labour and housing markets have been the chief pillars of optimism. I struggle to see how these undoubtedly positive developments have reached a self-perpetuating stage. The odds of significant set backs are not negligible, in my view.

A feature of recent earnings season in the US has been a very positively skewed distribution of net income surprises. This was not the case for the distribution of sales surprises, however. These have remained weak. Clearly, the chief factor behind better ‘results’ was cost reduction rather than revenue expansion. On the positive side, this says that companies are adapting quickly, but it is equally true that this is not a sustainable model for profit maximisation. With both expectations and operating leverage now at higher levels, it is that much more crucial for revenues to push on in the quarters ahead, or else the disappointments can be quite severe.

The markets are clearly optimistic that the US housing sector has hit bottom, and that employment conditions may be turning. Existing home sales reports in the US have come in modestly better than expected. However, the recovery seems limited to very select areas where prices have declined significantly. On the broader housing market in the US my view is less optimistic given the still large inventory overhang in this market. Even though stocks of unsold homes have come lower compared to their peak, future foreclosures could keep these high. The risk of further negative equity impact US household balance sheets still exits.

While most on the street continue to see the labour market as a lagging indicator in any economic cycle, I believe that in a balance sheet adjustment process such as the one US is undergoing, the labour market is probably the single most important leading indicator of the households’ ability to begin saving less and spending more.
The four-week moving average of initial jobless claims has come lower from its peak seen in April, but the work done by San Francisco Fed (see
FRBSF Economic Letter, “Jobless Recovery Redux?” June 5, 2009) suggests that any recovery is likely to be a jobless one. A detailed reading of the labour market shows that while companies may have slowed down the pace at which they are letting staff go, new hiring intentions remain very weak. Even the prints on average weekly hours worked by existing employees, that must rise before overall employment can pick up, still remain weak. The unemployment rate in the US may yet push well above 10%.

The Chinese economy does seem to be a clear positive for global risk appetite. The Politburo and the People’s Bank of China have shown much greater willingness to accommodate growth than worry about the pace at which they are expanding loans. It is noteworthy that unlike the US where money and outstanding credit are headed in different directions — almost a textbook definition of a ‘liquidity trap’ where monetary levers fail to pump the economic stimulus into economic engines — in China we witness the more typical situation where money and credit are expanding together simultaneously.

The quality of growth in China has not been ideal given that it has been driven largely by public investment rather than private spending or net exports, but this has not detracted most investors. If Chinese authorities continue to provide liquidity to the economy at the same pace, this stimulus is very likely to find its way into the asset markets. That is short-term bullish for equity markets in the Asian region, but may be a big worry over the longer term if it leads to unjustified valuations, lack of policy credibility and volatility in asset prices and output.

Global leaders have made encouraging promises on continued stimulus and limiting protectionism. They may well succeed in the first but I am sceptical they will pull the second one off. In my view, over the longer term most other governments that have passed strong fiscal stimuli will look to limit the import leakage of the fiscal multiplier. The last thing they will want is for 90 cents in each dollar they have added to their public debt to find its way in stimulating economies and labour markets away from their shores.

Many investors underestimate how truly special the previous 20 years have been in financial market history. Strong forces such as deregulation, privatisation, independent central banks, free movement of labour and capital and information technology together made for economic conditions that created a secular decline in goods prices while assisting strong increases in asset prices. Volatility in output and in financial markets
showed a trend decline. Some economists spoke about the disappearance of the business cycle and the Phillips curve. Not so. Greed got the better of caution, and jargon the better of ethical and common sense leading to a dramatic failure in global capitalism. Several Asian leaders still remember with some distaste the unpleasant years of adjustment based on policies prescribed by the IMF, who many in
Asia saw as a Washington’s mouthpiece. Ten years and several trillion dollars worth of US debt later, the US Fed and US treasury have undertaken almost exactly the opposite set of economic measures as they struggle to fight their own battle. Emerging Asia, which over time has transformed into the lender in the fancy leasing-finance scheme that comprises our global imbalances, has made obvious its disapproval in tit for tat admonishing, and maintaining a sense of history, it’s difficult to blame them.

Yet, the risk is that many governments in emerging markets will emerge from this crisis more convinced that they had too few foreign exchange reserves rather than too many, and that they continue to push ahead with mercantilist policies. The resulting increase in protectionism could lead to a decline in international mobility of labour, capital and traded goods/services. This is neither good for productivity nor for costs. Visionary policy making may yet keep the global economy going down that slippery slope but I would not bet on it.

(The author is Managing Director and Global Head of emerging markets fixed income, sovereign credit and currency strategy at UBS AG. Views are personal.)

source: Economictimes

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