My Diary 642 --- The Lessons from The Past; The Challenges at The Present; The Outlook for The Future
Saturday, July 10, 2010
“The history of World Cup will be made, what about stock market?” -- I had the topic as my presentation in Beijing over the weekend. And this diary will mainly summarize my observations and views to the past, the present and the future of stock markets. The ultimate question is the prospect of emerging markets’ equities, in particular Asia. That said a s far as laggard markets go in Asia, A-shares take the cake at -26% YTD. H-shares take 2nd place at -9% and the HSI 3rd place at -7%. Taiwan is not far behind at -8.4%. In contrast, India market (+1%) looks like bulletproof, even the country sees twin deficits, rising inflation, rising interest rates and the most expensive valuation (16XPE10) among emerging markets.
Macro side, global economy seemed still on the recovery track as the IMF just raised its expectations of global growth to 4.6% in 2010 (4.2% in Apr) and 4.3% in 2011. However, they also warned that weakened commercial real estate poses risks to banks. Major central banks’ policy decisions, including Fed, BOE and ECB, were boring with no change from either and no earth shattering comments either. However, The Governor Zeti in Malaysia showed us how it is done by unexpectedly hiking rates by another 25bps to 2.75% (3rd time in 2010). The divergence of policy exit strategy clearly reflects the growth divergence which I will discuss later.
Let us now switch the gear to the three questions I will elaborate in the rest of this diary, including 1) how can we get here? 2) What are the problems we are facing now? And 3) what is the next?
The Lessons from The Past
If one has the chance to look through the past 130 years of US macro economy, there is one thing stands out quite clearly, that is, economic life was a lot more volatile in the 1H than in the 2H (or the post-WWII period) which was a lot calmer on both fronts. However, if one can read more closely, then the 1H of US economic life can be divided into two phases --- 1) prior to the 1930s: it truly was a laissez faire economic world. Booms and busts in the economy and the markets often were violent because there was not much in the way of government interference. 2) Then along came the Great Depression: the US governments realized that they could not let that happen again, so we had the real start of government involvement to try and smooth out business cycles, including deposit insurance, unemployment insurance and fiscal spending on public projects. Certainly, it was the theories of John Maynard Keynes gave legitimacy to this by showing how governments could and should use fiscal policy to counter the swings in the economy.
Obviously, government intervention achieved the desired result, but with a problem embedded. Once governments intervened to smooth out business cycles, the excesses created during the expansions did not get fully cleansed in the downturns. Thus, each upturn began with debt and imbalances higher than in the previous cycle, and so began the ever-rising trend of private-sector indebtedness (from 70% to 180%) – and the Debt Supercycle was born. That being said, debt is not evil and several forces were behind the rise in indebtedness, including financial innovation and falling interest rates.
What we can probably date the start of the problems to the late 1960s. When faced with pressures to do something about the balance of payments, the US chose to "close the gold window” in August 1971 by President. This gave US government the freedom to pursue inflationary instead of deflationary policies. In subsequent decades, the authorities resorted to easy money, fiscal deficits and a lower dollar to boost demand. Over time, financial imbalances continued to build up, with the authorities simply creating the potential for even greater problems in the future. The recent cycle was a classic example of the Debt Supercycle at work. After the tech bubble burst in 2000, concerns about the potential economic damage led to massive policy reflation. The Fed cut rates to 1% and kept them low for quite a while, budget surpluses turned into large deficits, and USD dropped by +30% against other major currencies in the 1H of the decade. It all worked perfectly. There was barely a recession at all in US in 2000-01, despite the bursting of an immense stock-market bubble. However, policy reflation sowed the seeds of the housing overshoot, which involved an even greater buildup of excesses than during the tech mania. That begs the question of what mess today’s actions are creating for the future.
Along with government intervention and policy reflation, the world also saw a truly explosive expansion of the financial services sector during the past 30 years as a result of financial deregulation and innovation. Prior to the early 1980s, the ratio of overall financial assets to the economy was broadly flat. The financial system was unsophisticated, but it worked reasonably well. This all changed after the early 1980s, illustrated by the dramatic rise in the ratio of financial assets to the economy (from 4X to 11X). There are many other ways to highlight the dramatic growth of the financial services sector. One can also see it in employment, the number of mutual funds and hedge funds, derivatives activity and financial sector profits.
With stable economic growth and excess liquidity created by financial innovation, there are two other important drivers which helped created one of the largest bubbles in the history --- a) the decline in inflation and b) the asset allocation to equities. First, and most importantly, at the end of the 1970s, the Fed under Paul Volcker decided to squeeze inflation out of the system (FFTR from 4.75% in 1975 to 20% in 1980-81), and this battle lasted for the next 15-20 years. Inflation eventually fell from double digits (14.8% in Mar1980) to low single figures (1.2% in Dec1986), leading to a parallel drop in interest rates. The decline in interest rates was of course very bullish for bonds and also led to a dramatic rerating of stocks. The decline in inflation helped trigger the second pillar of the bull market. No longer able to simply pass on costs to customers, companies had no option other than to become more efficient, further encouraged by widespread deregulation in many industries. The result was a marked revival in corporate profitability, giving additional support to the rise in equity prices. The last force was a gradual shift to equities on the part of institutions and the investing public. In the early 1980s, equities were a detested asset, as they had gone through a brutal 14-year bear market and high interest rates made bank deposits seem an attractive and safer alternative. Thus, equities represented a relatively modest part of investment portfolios. This changes progressively, as a rising market creating growing enthusiasm. Mutual fund industry also expanded. As a result, we had 18 years of compound double-digit returns from both stocks and bonds between 1982 and 2000 – the greatest combined bull market in stocks and bonds in history.
The party can not last forever and it ends in 2008. What is unusual this time around was the destructive scale of the bust. The loss of real estate and equity wealth was the greatest of the post-WWII period, equal to about 150% of GDP over a two-year period. Looking back, the roots of this crisis lay in a system that had grown increasingly vulnerable because of a) high debt levels, b) a financial sector that had become extremely large and complex, and c) authorities that was always ready to ease policy rather than encourage B/S rebuilding. Clearly, during the past 2 years authorities across the developed world are using government balance sheets to reflate their domestic economies and buy what could be the last leg of the Debt Supercycle.
To sum up, there are four lessons we can learn from the past – 1) Regulatory landscape: the 2008-09 crises marked a major turning point in government involvement and regulation of the financial system. The financial sector’s glory days are over. Increased regulation, more taxes, and limits on capital and leverage will limit the sector’s ability to generate excess profits for a long time to come. 2) Central bank policies: central bankers have been forced to abandon a long and deeply-held belief that as long as they focused on low and stable consumer price inflation, then everything else would work out fine. Their new mandates will surely include: systemic risk management, financial market stability, employment and etc. 3) Macro economy: the answer was discovered to a long-asked question about where the limits were to US household debt. It seems that they were found. But, it seems that if consumers will not borrow and spend, then governments are doing it for them. The key issue is the Debt Supercycle has reached an important turning point. The federal deficit has reached an unbelievable USD1.5trn, and the debt-to-GDP ratio is on track to double in a few years. The cyclical trend in government deficits and debt took a marked turn for the worse at a time when the long-run structural outlook was already very bleak. 4) Financial markets: Credit-fueled asset booms always will end badly. In a sense, increased indebtedness is like a giant Ponzi scheme. Moreover, there is a simple rule that if you want to know where the next crisis will be then look at where the leverage is accumulating today. And it is in governments.
The Challenges at The Present
The lessons from the recent crisis are still being learned, and the issue of where we go from here is shrouded in a thick fog. Thus this leads to the next question regarding the challenges at the present. In my own views, there are 4 global challenges which are part of the consequence of the latest crisis and the unprecedented policies taken by global government authorities. These include 1) economic growth imbalance, 2) global trading system, 3) central bank exit strategies and 4) fiscal deficits and public debts.
I) Economic Growth Imbalance,
There has been no major country in the world that did not shrink in 2009. Looking forward to 2010-11, it looks like a better year. However, the problem is we see the world masks great diversity or growth imbalance, in particular the DMs vs. EMs. The important point to note is that the engine of the world has become the emerging markets. In 2009, of the world growth, more than 90% came from the emerging markets, less than 10% from the industrial world. In fact, this would be the medium term scenario based on the IMF’s forecast of the share of global GDP growth, of which Ems contribute +75% during 2007-2012. China as a single country will contribute 33.9% of global GDP growth from 2007-12. In addition, even during the developed countries, there also see the divergence. According to the latest ECB comment, “...while it looks as if employment contraction has stabilised, the divergence in unemployment rates across European economies is now at historical highs...”
In general, I am bearish on the developed economies’ growth. The multi-year consequence of the 2008 meltdown is that the US consumer is unlikely to be the large source of growth that it was in past decades. The demographic profile of advanced economies has been an obvious long-term warning of the eventual slowing in potential growth in most of the developed world. Meanwhile, sovereign debt woes may continue to weigh on consumer and business confidence. The euro area accounts for ~12% of world GDP, but is expected to contribute only about 3% to global growth in the 2007-2012 period.
The recent market worries over the “double-dip” in 2H10 are not unwarranted. In this vein, much focus has been paid recently to the rates markets which suggest a growing chance of a double-dip recession. Historically, rates market tends to sniff these things out before other markets do. The 10-year UST yield, having approached 4% in early May, was now sitting at 2.93% in last Tuesday. Remarkably, 10-year Treasury yields elsewhere in the G7 are now below the post-Lehman panic nadir. This could be warning signals, if not confirming ones. The latest US data softened notably in June, suggesting the recovery has lost momentum in light of global concerns and market turmoil, and confirming that the headwinds already in place continue to constrain growth. The downtrend in inflation gained momentum. While survey and hard activity data for the Eurozone point to relatively strong GDP growth in 2Q10, the most recent leading indicators indicate a loss of momentum going into 2H. Turbulence in the financial markets and tighter fiscal policy are biting. China’s recent data suggest that economic growth peaked in Q1. Overheating concerns have been replaced by intense worries over a sharp slowdown.
II) Global Trading System
In 2009 world trade has been shrinking by more than 10% and this has been the greatest danger. Why was it a danger? Because in an integrated world, one part of the world is doing poorly, it hurts the other part. If one looks at the global trading system, it seems the key is China now. The whole world looks much like a trading chain of which China is importing from Asia, adding value, and exporting to the EU and the US. On the one hand, it can be seen that China is exporting to the United States and Europe more than USD500bn, whereas the US and Europe is exporting to China about half of it. This is the essence of what used to be the trade friction, on the back of current accounts imbalances. It led to great tension which was misplaced, because in a trading system there needs to be a multilateral perspective. Indeed, on the other hand, looking at the relations between China and the rest of Asia. China is importing from the rest of Asia more than it exports to it.
Meanwhile, it is not deniable that global imbalances continue to witness by a situation where the US has a very significant deficit in the current account - more than USD400bn - and Asia has a very significant surplus, with China having around USD390bn. That being said, China has accumulated a huge amount of international reserves, which is now about USD2.5trn. Most of it has been accumulated in the last five years. This has been attacked by China’s global trading partners with a out-crying consensus on undervalued RMB. Now the question is whether the world can deal with this imbalance through RMB appreciation? I doubt!
China’s advantage in manufacturing is more than low costs. It has increasingly superior infrastructure, spreading industrial clusters and a vast domestic market that enhances productivity, allows for easier business integration and fosters economies of scale. Chinese wages are neither the lowest in terms of levels nor the slowest in terms of growth rates among developing countries. But the country remains a top recipient of FDI, even in 2009. The advantage in Chinese manufacturing has taken decades to build and is impossible for other countries to replicate within a short period of time. Some fear that rising wages will sweep out lower margin manufacturers and exporters. This is a legitimate concern , but it is important to note that Chinese exporters have been consistently gaining global market share in the past two decades regardless of global business cycles, despite rising wages, higher material input costs and in particular an appreciating RMB. This means that the manufacturing sector’s ability to adjust is much higher than the government and market have anticipated, i.e. through climbing up value chain.
III) Central Bank’s Exit Strategies
The adoption of QE by major central banks in 2008–09 crises to prevent a deflationary spiral in the aftermath of the burst housing and credit bubbles is one of the key differentiating factors from the other crisis in the past 20 years. The balance sheets of the BOE, of the Fed and of the ECB, have all expanded very significantly (2-3X). Obviously, their challenge will be how to reverse it in due time? In addition, during the recession that was in the crisis of the previous two years, monetary authorities all over the world reduced interest rates almost to zero. When and how quickly should they hike?
The answers are very much based on the underlying economic activities. Based on the global CPI and capacity utilization rate, the upturn in underlying economic activity will be considerably more gradual and disinflationary pressures remain. CPI ex food in Japan has fallen even as the central bank’s bond holdings rose to a four-year high in February. US core CPI rose 0.94% in May from a year earlier, near the slowest pace in more than 40 years. Goldman Sachs said the inflation rate is headed toward zero. Similar euro-area prices climbed the least since 1991. That said, the global economy faces deflation threat and this is why central banks extend their two-year-old policy to stimulate growth. The Fed raised government bond holdings to equal about 16.1%of GDP last month, from 6% before the global financial crisis. The ECB boosted its portfolio to 24% from 16%.
As a result, the primary near-term risk is a premature exit of monetary or fiscal policy. A withdrawal of stimulus at this stage in the US, Japan, EU or UK would threaten the sustainability of the recovery and could lead to a double-dip recession. Despite the benign outlook for inflation over the next year, there is a risk that price pressures gain upward momentum over an intermediate- or longer-term horizon if policymakers prove reluctant to remove stimulus as banking system health is restored and the economy returns toward trend growth. Based on the empirical analysis of the decade averages of broad money growth and inflation from the early 1900s, US will see 4.2% inflation as M2 has grown by about 7.6% over the past year.
IV) Fiscal Deficits and Public Debts
All over the world, all governments are now running large deficits. It was justified at the time by the need to overcome the slowdown. But the nature of the fiscal deficit is that you borrow to finance it. As you borrow, you accumulate debt. So it is not surprising that the debt of the major industrial countries in the world has been growing up significantly. The urgency is that it seems that the tsunami of public debt is so great that policymakers cannot delay in tightening their budgets. Under current policies, debt-to-GDP ratios will rise exponentially. Finance ministers do not have the luxury to wait a few years before implementing austerity programs. They must begin immediately.’
Having discussed so, there is no way to discuss today’s financial market without touching on the matters of European Sovereign Debt Crisis. Looking at the budget deficit vs. government debt, no wonder Greece is celebrating there, so are Portugal, Ireland and Spain. But I think the key for European sovereign debt crisis is to prevent contagion from spreading into banking system. The massive increase in ECB deposit facility usage and overnight swap rate is a concerning sign that banks may know something disturbing. The CDS and bond spreads of European banks are surging to new highs as their share prices hit new lows. The latest data shows that banks across the region have substantial foreign exposure to the weaker euro area members, holding roughly USD2.6trn in Greek, Italian, Portuguese and Spanish debt. Default or debt restructuring could absorb a significant portion of these banks’ tangible capitals. In a worst-case scenario, about half of European tangible equity capital could be eliminated. While the probability of this outcome may be low, it highlights the need for aggressive policy support.
To sum up, we have both fiscal and monetary policies face challenges ahead. The large public sector deficits and growing debt levels will lead most major developed economies to tighten fiscal policy. To monetary authorities, the main risk is not CPI inflation, but another bout of asset inflation, which could potentially sow the seeds for yet another crisis in a few years time. The primary near-term risk is that an early exit of monetary or fiscal policy derails the recovery and leads to a double-dip recession. In contrast, the intermediate-term risks are related to the inflationary consequences of a late exit by policymakers. I think major central banks are well aware of this risk but will need to ensure that inflation expectations remain capped in order to avoid being forced to hike prematurely. As a result, major central banks will be very slow to exit from their accommodative policy stances, keeping global liquidity conditions super-abundant.
The Outlook for The Future
It is easy to conclude here that global monetary and government authorities are facing policy dilemmas. Firstly, policymakers need to balance the need for greater financial sector regulation vs. lowering bank profits, which will reduce their willingness to extend credit and support the economy. Secondly, early monetary tightening could destabilize financial markets and endanger the recovery, while staying accommodative may fuel asset bubbles. Thirdly, tightening fiscal policy too soon and by too much could make a sovereign debt crisis more likely. The scope for policy errors cannot be dismissed, meaning investors face fat tail risks.
For the market fundamentals, the world will continue to be highly deflationary in the short term and economic growth will stay low for a long time. The government faces double headwinds as both private and public sectors are in a painful deleveraging process. In an environment like this, central banks are unlikely to raise rates any time soon. Thus, I have a positive investment bias in the near and medium terms, regarding the emerging markets as easy monetary policy is generally bullish for stocks when the economy is recovering from trauma. Liquidity will continue to improve and economic recovery is on track and profits should remain strong in the near term
But, the long-term outlook is particularly cloudy because of persisting imbalances. Thus investors should focus on wealth preservation in an environment with increased volatility. Investors need benchmarks to watch closely, which include stability in the US dollar, US Treasuries, and corporate bond spreads. I would prefer to invest in the equities of high-quality companies with good balance sheets, management and businesses. The key indicators to watch under such an economic and market circumstance are job growth, European sovereign/bank CDS and China’s policy
My preference to EM equities comes from two fundamental angles – 1) growth: based on the above discussion, it remains a tale of two worlds: a fragile West, and a far more buoyant East. In particular, most of EM countries enjoy CA surplus along with high domestic saving rates and the low fiscal debt burden. As a result, I observe a subtle shift in investor “safe haven” perceptions. In the past, while DMs displayed less volatility than EM at times of crisis, the opposite seems to be occurring this time. EM economies are now seen as safer. In this context, the performance of the MXEM index vs. SP500 shows the EM index has become less volatile over time. Thus, I believe that emerging markets, especially Asia, will continue to attract investor interest, once market feel convinced that contagion from the Western world will be contained. 2) Valuation wise, from a global perspective, EM equity’s investment value emerged, as MXEM forward PE (10.5X) is trading at 1.5 STDEV below the 10-year average (13.8X). In China, A-share / H-share premium is below zero, the first time in 3 years. Thus, either from a static view or from a dynamic view, emerging markets, in particular Asia has been attractive to investors who take global asset allocation strategy. Asia's long-term story remains attractive. Growth in China, India and other Asian economies is likely to remain well above that in developed economies for years to come, with fewer structural risks. In the near term, i do not foresee a double dip. As long as earnings growth comes through, Asian stocks can continue to rise steadily.
Good night, my dear friends!
