With the reversal of emergency economic measures in 2010, something nasty may surface.
The year 2010 is shaping up to be a very interesting year indeed. After two years of huge oscillations in equity prices, can we expect a more sober and measured market in 2010? After the wild swings of 2008 and 2009, it is unlikely that returns in 2010 (in either direction) will be as dramatic.
My starting assumption remains that equity markets (in the developed world at least) are not in the midst of a new secular bull run. Secular bull markets require cheap starting valuations, strong, accelerating and sustained economic and earnings growth, as well as easy liquidity and rising leverage. None of these three factors are in play in 2010.
The most likely outcome remains that this current rally ends in the first half of 2010, we get a short and sharp correction, and then an extended range trading market for some time after that. This is historically the template for equity markets in the aftermath of secular bear markets as outlined by the folks at Morgan Stanley in numerous publications.
The immediate question is, of course, as to what can short-circuit the current rally.
The obvious cause will be the normalisation of fiscal and monetary policy, as we remove the various emergency measures put into operation in 2009. As we exit these support measures, the global economy will be stress-tested as to the true durability of the recovery. The other outcome will be the effects on interest rates, with rising rates a clear negative for equity multiples. If bond yields in the US normalise to higher levels (as real rates rise), beyond its impact on valuation multiples, given the continued high leverage in the system, any rise in yields will be a big negative on consumption and growth. Can US consumers in their current weakened state handle significantly higher rates? It is not clear that markets can handle a normalisation of monetary and fiscal policy, but normalisation is a given in 2010, it will happen. There is bound to be turbulence around this.
The other factor which could snap the rally is a wake up call as to embedded earnings growth assumptions. This rally, as is typical of rallies from a bottom, has been all about price-to-earnings (P/E) expansion, as markets discount an economic and earnings recovery. Now, however, in 2010, earnings have to catch up as the P/E expansion phase is over. Markets will now move with earnings. I doubt that earnings can surprise hugely from here, given the still subdued economic recovery that one expects. Margins are already at record levels and if economic growth is sub-3 per cent, with limited inflation, a nominal GDP growth rate of 5 per cent is not conducive to strong absolute earnings growth. Consensus earnings growth expectations seem too high. If earnings falter vis-a-vis rising expectations, that could be the reality check needed to snap the current rally.
Thus, in 2010, we will see markets have the headwinds of rising rates, not inexpensive valuations and limited possibility of any further upgrade to growth or earnings expectations. This is the exact opposite of 2009, when rates were being cut and, at record lows, earnings and growth expectations were rising and markets were able to re-rate.
There also exists the possibility of another shoe-dropping in the OECD world in 2010. We could see a sharp counter-trend rally in the dollar, which could reveal a lot of skeletons, and, of course, everyone is now worried about sovereign issues, with Greece being in the spotlight currently. As the emergency economic measures are reversed, there does exist the possibility that something nasty surfaces, hidden currently by all the government and central bank liquidity support.
If this is the outlook for the developed markets, then how should one approach the emerging market (EM) asset class? First of all, if we do get the short, sharp correction that one expects, even EM equity markets will get hurt. However, in the subsequent range trading environment, one should expect these markets to once again begin to outperform. The dynamic to move out of dollar-based assets as well as a desire to be where the growth is will combine to ensure continued flows into these equity markets. To the extent that liquidity is still sloshing around in 2010, the EM asset class is where it will go to.
As for India, I think once again it boils down to the level of comfort investors can derive about the long-term outlook for the country. We once again have a whole bunch of economic reform initiatives pending. From the PFRDA Bill, to the GST and direct taxes code, to opening up education and the land acquisition Bill. There are many things for the government to tackle and handle. Unless we see movement on these issues, I don’t see how the markets can go up significantly from here. To get market performance from here, the P/E multiples have to hold, which is unlikely in the absence of serious movement on these many fronts. The government has also got to show determination and resolve to bring the fiscal deficit under control. In the absence of fiscal moderation, interest rates will rise sharply as credit growth expands, significantly dampening market and economic performance.
India has so much low-hanging fruit, productivity levels are still so low across sectors that government policy matters. Anything on the policy front which can help raise productivity levels will have a huge multiplier.
In India, we will also have to tackle our own exit from low interest rates and government stimulus measures. Can the Reserve Bank of India balance growth with inflation? How do you calibrate monetary policy when you have double-digit food price inflation largely caused by supply shocks? How does the government balance cutting the fiscal deficit, through tax hikes, but not killing off the economic recovery?
India has the ability to attract huge capital flows, and, in fact, will need to do so in 2010 if the government is even half serious about the disinvestment programme, but we need to improve our absorptive capacity.
If the government takes action to move ahead on some of the issues highlighted above, then the markets can give a decent return even in 2010. However, in the absence of government policy action, the outlook looks tough.
The author is the Fund Manager and Chief Executive Officer of Amansa Capital
