Look­ing for the bright side

Financial Mirror (Cyprus) - - FRONT PAGE - Mar­cuard’s Mar­ket up­date by GaveKal Drago­nomics

By most mea­sures, the first two weeks of 2016 have been the worst-ever start of the year for risk as­sets. With the MSCI All-Coun­tries in­dex down nearly -20% from last May’s high, we are now in a global bear mar­ket.

All routs come to an end, even­tu­ally; the ques­tion of the mo­ment is what cat­a­lyst might emerge to stop the cur­rent sell-off, and how soon might this oc­cur. There are plenty of pos­si­bil­i­ties, but un­for­tu­nately none of them looks com­pelling any time soon.

The first would be a big in­crease in liq­uid­ity via mas­sive eas­ing by the main cen­tral banks, or though fis­cal stim­u­lus. Nei­ther is at all likely. The Euro­pean Cen­tral Bank and the Bank of Ja­pan are al­ready en­gaged in quan­ti­ta­tive eas­ing and have no grounds, based on their economies’ per­for­mance, to ease fur­ther. The US Fed­eral Re­serve is hik­ing rates, but mar­kets have al­ready priced in the ex­pec­ta­tion that it will de­liver only two of the four rate hikes it has sig­nalled for this year. Given the Fed’s ob­vi­ous de­sire to nor­malise pol­icy and the ro­bust state of the US labour mar­ket, it’s hard to see any ad­di­tional eas­ing there.

China will not be much help ei­ther. The Peo­ple’s Bank of China is cut­ting rates, but merely in or­der to sta­bilise credit growth, not to boost it. The to­tal credit stock grew by 11.5% YoY in De­cem­ber; high by most coun­tries’ stan­dards, but low by China’s.

Even so, credit con­tin­ues to grow faster than nom­i­nal gross do­mes­tic prod­uct, which is run­ning at about 7%. Hence na­tional lev­er­age con­tin­ues to rise, and the PBOC can­not push credit growth higher with­out spark­ing fears that it is push­ing China into a debt cri­sis. Sim­i­larly, the govern­ment is tar­get­ing a mod­est in­crease in the fis­cal deficit, but it has lit­tle abil­ity to boost in­fra­struc­ture spend­ing growth be­yond the 20% rate it has run at over the past two years.

A se­cond cat­a­lyst could be good news from the com­mod­ity sec­tor. One pos­si­bil­ity is a solid re­bound in the oil price. Ana­tole Kalet­sky is rea­son­ably con­vinced this will oc­cur at some point this year, and that the nat­u­ral trad­ing range for oil over the next few years is US$30-50. But the short-term mo­men­tum is down­ward, es­pe­cially now that sanc­tions on Iran have been lifted and Tehran is scram­bling to bring as much new oil to mar­ket as it can.

Al­ter­na­tively, we might see mas­sive con­sol­i­da­tion in the en­ergy and min­ing in­dus­tries, lead­ing to an im­prove­ment in re­turns on cap­i­tal. Again, this is doubt­less on its way, but it has not re­ally be­gun yet. And the ini­tial news flow about de­faults and bank­rupt­cies will prob­a­bly be neg­a­tive, not pos­i­tive, for mar­ket sen­ti­ment.

Third, val­u­a­tions could be­come so at­trac­tive that cash can no longer stay on the side­lines.

Small pock­ets of value are be­gin­ning to emerge, but we are still far from val­u­a­tion lev­els that would lead to a risk-on stam­pede.

Fi­nally, a big new growth theme might emerge to cap­ture in­vestors’ imag­i­na­tions, as with the in­ter­net in the mid1990s, and China in the last decade. If you spot one, let us know, be­cause right now we don’t see any on the hori­zon.

So in short, lousy mar­ket con­di­tions are likely to per­sist for a while longer. Is there a bright side? If you can stay sol­vent, there is. Ar­guably, this year’s crash is a re­ac­tion to the end of two ma­jor dis­tort­ing in­flu­ences. One was the Fed’s zero in­ter­est-rate pol­icy, which ar­ti­fi­cially boosted global as­set prices for seven years fol­low­ing the 2008 cri­sis. The other was China’s long-run­ning stim­u­lus pro­gram, which ar­ti­fi­cially boosted com­modi­ties and re­lated sec­tors un­til the end of 2014.

Painful as things might be right now, global mar­kets and economies are bet­ter off in the long run with the re­moval of th­ese eco­nomic hal­lu­cino­gens. Mar­kets got ad­dicted to the twin opi­ates of the Fed’s un­usu­ally low price of money, and China’s un­rea­son­ably strong sup­port for com­mod­ity prices. Now they are be­ing forced into with­drawal from both drugs si­mul­ta­ne­ously, and they are shriek­ing. But af­ter a pe­riod of re­hab, mar­kets should do a bet­ter job of gaug­ing what as­sets are re­ally worth.

And the world’s economies, with the ex­cep­tion of the worst-man­aged re­source economies (that’s you, Brazil), gen­er­ally seem more sta­ble than their fi­nan­cial mar­kets. Growth in Europe and Ja­pan, while hardly spec­tac­u­lar, is grind­ing higher.

China’s growth, while grind­ing lower, prob­a­bly did so at a slower rate to­wards the end of last year. And for all the woes of US man­u­fac­tur­ing, the health of con­struc­tion and the labour mar­ket con­tinue to be­lie re­ces­sion in the world’s big­gest econ­omy.

True, the mar­kets could be sig­nalling that worse is to come. But it is at least as likely that economies are sig­nalling that the mar­kets are over-re­act­ing.

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