Looking for the bright side
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.