Monday, November 29, 2010

Room For Additional Economic Stimulus Continues To Shrink, Stock Market Trend

Most analysts view the current correction on stock markets worldwide as unavoidable. Tensions in Europe linked to the public finances are on the rise, China is trying to restrict domestic credit supply, and the Fed faces a torrent of criticism at home and abroad regarding its policy to increase quantitative easing by $600bn with an option to draw down more. It is feared that further quantitative easing would only weaken the dollar further and push up commodity prices. As a result of the latter the rapidly growing Asian economies would come under additional inflationary pressures.

In response, these countries will tighten their monetary policies as the US and Europe – both major commodity importers – will have to pay more for necessary resources. This would fan inflation expectations, which are already being driven up by the ultra expansionary monetary policy of the Fed. At the same time, in a climate were wage increases are virtually absent and unemployment is high, rising commodity prices will eat up purchasing power that could have been used to buy other consumables. Investors doubt progressively more whether the Fed will continue its policy of QE after the “second round” that started early in November is spent, eight months from now.
Apart from any fundamental reasons, a correction has also been on the cards because the mood turned extremely optimistic, while equities have become overbought following a rally of almost 20% during September and October. The size of the downswing on the stock markets is as yet unclear. Opinions differ about the scope of the expected correction, from approximately 5% (if so, the reaction is already over) to 10%-20%. Should stock prices correct by 20% at the present juncture a double floor could shape up in the S&P 500 near 1,010. From there, the index could once again rise steeply. By far the majority of analysts believe that higher prices are justified in the long term because of:
  • Favorable valuations, especially compared to (government) bonds.
  •  The impression created by the Fed that the monetary policy will remain loose for now. If so, a lot of liquidity could flow towards the stock markets in the coming period, especially if the economic recovery persists.
We strongly doubt if this confidence is justified in the long term. In the first place we think that it is rooted in the fiscal and monetary stimulus, in the West as well as in China, which has in recent years ordered its national banks to provide credit on a massive scale, regardless of the economic benefits. Such stimulus measures have greatly underpinned the global economy and have staved off negative deflationary spirals, particularly in the West. Nonetheless, the limits to where the authorities can boost the economy “with impunity” are slowly but surely being reached or have already been exceeded in some cases. The European governments are no longer able (or willing) to implement a further fiscal stimulus as rising inflation forces the Asian authorities to cool their economies. In Japan and the US too there seems to be less and less room for boosting growth.

The latter is important. For without such (artificial) impulses, growth in the West – by far the largest market for consumables – is likely to stall. In the US as well as in Europe and Japan property and consumption goods have increasingly been purchased with borrowed money. For many years this helped consumption in the US to outpace wage earnings, which acted as a major source of profits for businesses. The credit crisis put a stop to this. As consumers continue to grapple with negative equity and high jobless rates, this situation is not going to change any time soon. All the more so as the population is aging. This implies that more and more capital needs to be set aside as an old age provision since rising asset prices can no longer be taken for granted. In other words, the focus has shifted towards reducing indebtedness. Banks have taken considerable steps in this direction but many consumers still have a long way to go. This implies that an expanding portion of disposable income (which is hardly growing at all in any case due to high unemployment and low wage rises) is required to pay off outstanding debts and build up savings.

Like many economists we think this process of deleveraging will continue for the time being. In itself this would not be such a problem if either the public sector or customers abroad would make up for declining demand. Yet public sectors in the West no longer really have the wherewithal, while other countries are beginning to face similar problems. Virtually none of the economies is prepared or willing to import more (as was evident from the latest G20 meeting). In other words, as long as debt is being paid down this needs to be compensated through artificial stimuli provided by either governments or central banks. This has created a situation whereby attempts are made to “solve” problems connected with high indebtedness in the private sector by running up even more debt in the public sector. This is not a structural solution. Furthermore, the financial markets are increasingly rebelling against this. As interest rates rise, the advantages of the proposed “solutions” will quickly be eclipsed by the drawbacks.

On top of this, over the past months investors have increasingly priced in consistently high profit growth. The risk is that they will extrapolate this towards the future whereas we think this substantial profit growth was largely due to once-off factors such as high increases in productivity, considerable fiscal stimulus measures, inventory rebuilding, and investment and consumption that had been postponed. The positive effect of such developments is now largely behind us. For instance, increases in productivity in the United States have already started to decline. This does not imply that profits are due to follow suit straight away. Still, we think an expectation of equally high profit growth in the coming period may well be overly optimistic.
For the aforementioned reasons we do not believe that equities are in a new bull market (supposedly from March 2009). A more likely option is that the upswing since March 2009 will turn out to have been a major bear market rally, now is on its last legs, mainly because the western authorities are running out of ammo to support the economies sufficiently to withstand the  negative impact of deleveraging. Long-term interest rates are a good indicator when it comes to assessing how much ammunition the governments and central banks still have at their disposal. Quickly rising interest rates suggest that the authorities have less and less room to boost the economy without adverse effects.

Therefore stock prices could drop sharply on balance in the coming quarters (S&P 500 towards 900). Also because bond yields will likely come under additional upward pressure in the near future (see also under “US short-term interest rates and bond yields”). In the short term prices could still hit a floor (S&P 500 near 1,150-1,175) before temporarily rising to new highs.