It is extremely gratifying to see equity markets behaving as I had instructed them to do a few weeks ago. They don’t usually follow instructions — mine or anybody else’s — but my last column (Mar 2) had forecast an equity rally and we had called the approaching end of the US recession as long ago as January in our research report, ‘The End of the Global Recession’.
Of course, most of the credit goes to our research team, although I do reserve a little bit for myself for approving publication of what seemed quite extravagant at the time. For most of this year, we were a loud majority of one, and my real concern had been that being the only one expecting a turnaround, it was possible that we were delaying it — the last optimist hurdle. Nonetheless, the good news is that more and more analysts are beginning to come our way and, occasional blips notwithstanding, equity markets globally have certainly signalled that they, too, believe the worst is behind us.
Continuing job losses and a return to reasonable growth are, of course, another story. As more educated pundits than myself have pointed out, equity markets usually turn around as much as six months before the economy does. My belief is that we will see the US economy return to positive growth — very, very modest, but positive — by the July quarter, at the very latest; indeed, I wouldn’t be surprised if we see it in the April quarter itself.
But the operative words are very, very modest. As we explained in our January report, the burnout of US housing assets and the attendant focus on saving will ensure that asset prices will rise very slowly over the next year, or possibly two. Thus, while we have come out of the bear market, it will take a long time before it turns into a bull. More likely we will have a prolonged period of a broad trading range — say, 7,000 to 9,000 on the Dow — while fundamental repairs take place. Clearly, it will be a good market for traders but not for investors.
The bond market will also be tricky. On the one hand, there is an explosion of government debt, which should depress prices; on the other, there is a lot of capital on the sidelines looking for a home, and there is the Fed, which has shown no shyness in circulating capital from the market back to the market. Again, it sounds like it will be a trading market.
And, as money goes around the block again and again, it would seem that inflation would be a sure shot by-product.
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Gold, the classic inflation hedge, is already much higher than it should be, evidenced by the fact that Indians are selling gold for the first time since the 1930s. Of course, this may also be a result of the unusually weak rupee, which is probably taking cues from fear of political instability. [It is remarkable how differently people in Delhi and in Bombay look at the markets — in Delhi, they are all but calling rupee weakness the Third Front (uncertain) effect; in Bombay, where the focus is more on the economy and capital flows, sentiment is much less bearish.] Perhaps gold has already been signaling the obvious fact that all this monetary and fiscal stimulation has to lead to inflation.
But while gold prices may not rise too much more — the $1,000 level seems to be a very stiff resistance — other commodities have also been showing signs of life. The CRB index, which is reasonably broad-based, has shot higher this month and is up nearly 11 per cent since the start of March. Oil is up above $50, and copper has crossed $4,000 — both of these are around 40 per cent higher than their December lows.
However, I believe it will take some time for commodity markets to really take off. First of all, global risk aversion is still very high — again, the VIX is down from its peaks, but still way above its long-term average. So, too, with many commodity markets. For instance, the volatility of oil prices is at 70 per cent — down from the 100-plus levels it reached at the start of this year, but still very much higher than the 30-50 per cent range it has held for the past ten years.
Copper, too, has become hugely volatile. In fact, for only the second time in nearly ten years, the volatility of copper is higher than the volatility of nickel, clearly a weird event. The volatility of a commodity is an essential element of its nature, and is determined by many specific factors including the discrete points of supply (which could readily be disrupted) against relatively continuous demand, and so on. Historically, nickel has always been much more volatile than copper. Thus, the negative volatility spread (driven by heightened copper volatility) suggests that something is afoot in copper that needs to be resolved before broad trends — eg, a continued rise in commodity prices — can assert themselves.
In the meantime, it would be a good bet to go long nickel volatility and short copper volatility — the long-term average of the spread is plus 13 per cent, whereas today’s value is minus 7 per cent.