Markets continue to remain very unsettled, and frisky. Over the last week, the latest stress points were over Hungary, some strangely timed comments on the euro out of France, disappointing payrolls data out of the US and continued poor price action with the S&P failing for the third time to break above its 200-day moving average. The markets are obviously deeply worried about the outlook and the concerns are no longer just Greece.
There is first of all deep concerns around fiscal sustainability across the EU. Spain is now seen as the real test, given the size of its economy and the extent of its troubles. The country already has an unemployment rate of 20 per cent, total indebtedness of the private sector exceeding 300 per cent of GDP, and huge banking system issues as a very large chunk of bank assets are in mortgage and commercial real estate (total property-related loans are over a trillion dollars). The country has a stock of unsold homes equal to four years’ supply at current sale rates. It is the sheer quantum of private sector debt that makes Spain so vulnerable to de-leveraging and ultimately deflation as the economy contracts. Yields on Spanish sovereign paper have already moved back nearly to where they were before the ¤750-billion bailout plan was announced. Spain is a greater than one-trillion-dollar economy, so any debt issues here will be tough for even the European Union to contain. The real bearish lot will, of course, argue that taken as a whole, neither the EU area’s fiscal position, nor its debt position are as bad on a weighted average basis (despite the issues in Greece) compared to Japan or even the US. These folks are convinced that all the issues we are seeing currently with Greece and Portugal are just a precursor to markets eventually attacking the world’s two largest economies. There is growing financial stress and fear in the system. Goldman has a proprietary financial stress indicator, which has deteriorated, though by only a modest amount and to levels which we have seen before many times in the past decade. The index is not even close to the levels reached in end-2008. The worry, of course, is that things get worse and this indicator continues to worsen. Investors need to keep an eye on funding and credit markets to get a grip on how this sovereign crisis is morphing, any signs of counterparty risk aversion will be a big red flag.
Fundamentally, the West has too much debt, whether it be at a government level or even for the private sector. Basically, countries accounting for nearly 60 per cent of global GDP need to de-leverage, to clean up their finances and improve their debt sustainability. In this process of de-leveraging, what will happen to economic growth, risks of deflation, chances of protectionism? Will these economies be forced to exit fiscal stimulus sooner than warranted by underlying economic conditions? What are the risks of a beggar-thy-neighbour approach to currency devaluations? These are all valid concerns, with no easy answers. How do you grow tax revenues and corporate profits when you have a nominal GDP growth profile of only 3.5-5 per cent? How do you bring about a fiscal correction of 500-600 basis points of GDP, without toppling the economy into a renewed recession? How do you avoid a debt trap when your debt carries a higher interest rate then nominal GDP? Can these economies avoid a debt restructuring package? These are some of the questions the markets are asking.
Just as markets are focusing on these issues, we have had a cooling off in most leading indicators of economic growth. It looks quite clear that the global industrial production cycle has moved past the acceleration phase. As Goldman highlights in a recent report, their global leading indicator is losing momentum and, across geographies, their financial conditions indices are showing tightening. Markets are always vulnerable when you have had a huge move-up in equities and you pass the peak in economic momentum. Markets tend to worry at this inflection point and need to digest this phase of growth adjustment when economic data stops surprising positively. Concerns on a possible double dip have now resurfaced among the bears. They fear that with an inevitable exiting of the emergency stimulus measures over the coming 12 months, growth is not robust enough to sustain organically.
What the bears are ignoring, of course, are some of the positives coming out of this market turbulence. The steep drop in crude oil is effectively a huge tax cut for the majority of the world, interest rates have actually declined for most economies outside of the most vulnerable (US mortgage yields are at new lows) and no one now expects any monetary policy tightening anytime soon.
At the same time, we have all the issues with China. Will the country have a hard landing? Does it have a bubble in the property markets? Can it contain the negative fallout from any property bubble burst? When will all the non-performing assets (NPAs) created in last year’s mad scramble to lend come out into the open?
It remains a very testing time, and investors are naturally cautious and unwilling to commit to a particular view without hard evidence. We are all back to being macro-investors, should one put on risk or cut risk is the big call, and your asset allocation will flow from this one decision.
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Markets are likely to remain choppy through the summer months before, hopefully, settling down in the autumn. Given the volatility, it makes sense to have some cash reserves.
Indian stocks have held up reasonably well in these last two months, with the real damage coming to international portfolios through currency depreciation. Hopefully, India can continue to hold up, for this we need more courage from the government than was displayed in the Group of Ministers meeting on Monday. Reform can put a floor under the markets. The monsoons are also critical, and if the rain gods are kind, then by mid-July, markets will start extrapolating a hopefully positive outcome on this front. Falling crude oil is another unalloyed positive to the India story.
Indian markets are setting themselves up for a strong move towards the second half of this year. However, investors may need to keep a strong stomach to handle volatility before we get there.
The author is the fund manager and chief executive officer of Amansa Capital