Friday, 17 April 2009

The only way is not up, it's sideways

Equity markets have probably stopped falling, but that doesn't mean they are now on an upward trajectory. They were pricing in Armageddon, which hasn't materialised, so the rally brings markets back in line with fundamentals, which are weak. However, it is fair to say that we have seen the lows of this bear market, since a further severe decline in fundamentals would be required to push prices to new lows.

From an economics standpoint, the fall in output has caught up with the fall in demand, which should prevent further deterioration in industrial production. Indeed, whilst retrospective indicators show no sign of improvement, current sentiment & demand indicators such as US & UK Manufacturing PMIs show signs of improvement, as the chart below demonstrates.

Indeed, Fed Chairman, Ben Bernanke, commented this week that:

"Recently we have seen tentative signs that the sharp decline in economic activity may be slowing, for example, in data on home sales, home building and consumer spending, including sales of new motor vehicles... A levelling out of economic activity is the first step toward recovery... [However,] we will not have a sustainable recovery without a stabilisation of our financial system and credit markets"

However, this is not cause for celebration as it is unlikely there will be a substantial bull market or significant economic recovery, merely a period of low growth punctuated with large fluctuations in asset prices, both up and down, for the foreseeable future. Indeed, this was the case in Japan, where, despite having peaked in December 1989 and falling 75% to March 2009, the TOPIX had a number of very large bear market rallies over the period (see chart below).

In fact, Barclays Capital noted this week that:

"US data have surprised to the upside to some extent over the past month or so. But sooner or later, the recovery in risky asset prices is unlikely to be sustained if some of the more important economies do not show convincing signs of recovery."

So, failing a sustained improvement above expectations, the current 25%+ rally in world equities may yet turn out to be another in a series of bear market rallies to come.

Therefore, expect interest rates to be kept low for the foreseeable future and inflation to remain subdued whilst growth remains stagnant. Moreover, given the amount of monetary stimulus that will eventually have to be removed, there is a high margin for policy error, increasing inflationary risks on a longer term perspective.


  1. It would appear Marc "Dr Doom" Faber agrees...

    Markets Are Overbought, April 18, 2009

    The market very near term has become somewhat overbought, and the correction should essentially follow, but I doubt it will go and make new lows in the intermediate future. The lows in early March at 666 in the S&P will hold, and we’ll have another push up into July.

  2. FT's Martin Wolf on "Why the ‘green shoots’ of recovery could yet wither"... (selected highlights only)

    Is the worst behind us? In a word, No. The rate of economic decline is decelerating. But it is too soon even to be sure of a turnaround, let alone of a return to rapid growth. Yet more remote is elimination of excess capacity. Most remote of all is an end to deleveraging. Complacency is perilous. These are still early days.

    Consider obvious perils: given huge excess capacity, a risk of deflation remains, with potentially dire results for overindebted borrowers; given the rising unemployment and huge losses in wealth, indebted households in low-saving countries may raise their savings rates to exceptional levels; given the collapse in demand and profits, cutbacks in investment may be exceptionally prolonged and severe; given massive and persistent fiscal deficits and soaring debt, risk aversion may lead to higher interest rates on government borrowing; and given the flight from riskier borrowers, a number of emerging economies may find themselves in a vicious downward spiral of weakening capital inflow, falling output and reductions in the quality of assets.

    The danger is that a turnaround, however shallow, will convince the world things are soon going to be the way they were before. They will not be. It will merely show that collapse does not last for ever once substantial stimulus is applied. The brutal truth is that the financial system is still far from healthy, the deleveraging of the private sectors of highly indebted countries has not begun, the needed rebalancing of global demand has barely even started and, for all these reasons, a return to sustained, private-sector-led growth probably remains a long way in the future.

    The world economy cannot go back to where it was before the crisis, because that was
    demonstrably unsustainable. It is at the early stages of a long and painful deleveraging and
    restructuring. Fortunately, policymakers have eliminated the worst possible outcomes. But there is much more yet to be done before fragile shoots become healthy plants.

  3. Nouriel Roubini confirms his belief that "we are still a long way away from the economic bottom and from a sustained recovery of growth" via his blog, RGE Monitor. The RGE 2009 Global Economic Outlook is summarised below:

    The global economy is in the middle of a synchronized contraction that will push global growth into negative territory in 2009 for the first time in decades. . This will be the worst financial crisis since the Great Depression and the worst global economic downturn in decades. Global trade volumes face their sharpest contractions of the postwar era – trade is expected to contract 12% in 2009 due to the severe and prolonged global demand slump, excess capacity across supply chains and the continued crunch in trade finance.

    Many analysts and commentators are pointing out that the second derivative of economic activity is turning positive (i.e. economies are still contracting but a slower rather than accelerated rate) and that green shoots of an economic recovery are blossoming. RGE Monitor’s analysis of the data suggests that the global economic contraction is still in full swing with a very severe, a deep and protracted U-shaped recession. Last year’s economic consensus forecast of a V-shaped short and shallow recession has vanished. While the rate of economic contraction is slowing compared to the free fall rates of Q4 of 2008 and Q1 of 2009, we are still a long way away from the economic bottom and from a sustained recovery of growth. In particular, in Europe and Japan there is little evidence of a positive second derivative of economic activity.

    However by the end of Q1 2009, there were some signs that the pace of contraction had slowed in many economies especially in the U.S. and China, where policy responses have been more significant and leading indicators in the manufacturing sector may have bottomed before they did in Europe and Japan. However, major economies including all of the G7 will continue to contract throughout 2009, albeit at a slower pace than at the beginning of the year.

    Moreover the global recovery might be sluggish at best in 2010 given the overhang of credit losses of financial institutions, lingering credit crunch, need for retrenchment by overstretched and over-indebted households in current account deficit countries and a slow resumption of demand prompted by extensive government stimulus.