Beware of gravity!

The equity market is in a gravity defying 'sweet spot' of low interest rates, QE, returning M&A, cash rich, yield hungry investors, and earnings and economic fundamentals are working off ultra low bases. Of these elements, the most likely tap to be closed off first is QE, then interest rates, which will probably be the catalyst for gravity to take over.

Chaos theory: a pig flaps its wings in Mexico...

Swine flu is a sideshow, blown out of proportion by the media. Having rallied over 25%, equity markets were vulnerable and looking for an excuse to go lower even before the outbreak.

To date, and tragically, swine flu has accounted for 149 deaths in Mexico, a country of 111 million people. This represents 0.0001% of the population.

So, if swine flu is no more of a serious and lasting issue to world health than SARS or bird flu were, there are bargains to be had in those sectors particularly hit by pandemic hysteria.

Airlines, in particular, come to mind, as do other travel sectors such as hotels. However, these sectors were already struggling in the face of the global slowdown, and companies with stressed balance sheets may be at risk.

George Soros interview with Bloomberg

The following are excerpts taken from a transcript of Bloomberg interview with George Soros on 6th April 2009...

The effect of the Western financial crisis on 'periphery' countries
After the bankruptcy of Lehman, the countries - the United States and the European countries - felt obliged to effectively guarantee their banking systems. And saying no other financially significant company will be allowed to go into bankruptcy. But countries at the periphery were not in a position to provide similarly convincing guarantees. And there was a flight of capital from the periphery to the centre. And that is what precipitated the crisis in Eastern Europe; and of course, in Brazil as well. So that was the unintended side effect of this artificial life support. And now that some support is extended by empowering the IMF, and also coordinating better the banking regulations.

China
China is now also simulating domestic growth. They have a pretty big stimulus package. And it is not enough. They are going to use more because not being a democracy, they know - the leadership knows - that their very survival, the avoidance of social unrest, requires them to generate growth. So they will - that’s for them the top priority. And they are in a position to do it. And so China is going to be coming out of their recession before the end of the year. And they will also try to maintain exports by providing credit to other countries. After all, they provided a lot of credit to us. Now they just made a swap agreement with Argentina. And they will similarly do the same with other countries in Africa, Latin America. And so they will actually restart their export industry, too.

Brazil
I think Brazil is another country that’s relatively well-situated. It was doing very well until the Lehman bankruptcy and the sudden collapse. And then you had a crash in Brazil. It did a certain amount of damage. But I think Brazil will also be a country that’s coming - will come out of the recession relatively soon. They have a big deal with China, I think invested something in the neighbourhood of $10 billion to develop the new oilfields there. China will be an avid buyer of Brazil’s soybeans and so on. And eventually will again buy their iron ore. So I think Brazil, actually - together with China, will be among the recovering countries. I don’t know about rapidly recovering, but I think the outlook for Brazil is better than for most other countries.

Oil
It’s very much a question of when does the economy recovery. Because when the world economy recovers, the price of oil will recover. And since the world economy suddenly collapsed, the price of oil collapsed. It hit a low below $40 from $140. And now it’s slowly climbing up. But the longer-term future deliveries never fell that far. And in fact now oil is about $50. And it will probably recover perhaps to $70 or so because the marginal cost of developing new oilfields is around $70. Maybe that will fall if prices fall. So it may be lower. But $50 to $70, somewhere in there.

You see, this is a clear example where you have that conflict between the short term and the long term. Because in the long term, there is no question that first of all, the cost of discovering oil is getting bigger and bigger. And the really large oilfields are getting exhausted. There hasn’t been that much new very large discoveries, except, let’s say, in Brazil in very, very deep and very far out waters. And as the Arctic ice melts, then under the Arctic Ocean, we will find oil. But that’s going to be quite expensive. So long term, price of oil has to rise. And we do have this very serious problem of global warming, which really requires us to develop alternative forms of energy, which are also initially, more expensive than the existing sources. The big difference between the new - the alternative sources that with time, their costs may decline. So right now, let’s say solar energy, is more expensive than natural gas. However, as you develop the technology, those prices may rise. So we have no alternative but to develop those. But the collapse in prices short term has really pulled the rug out from under all these alternative sources of energy. And that is directly counter to what we need in the long term. So here’s another example where the short term is directly contradictory to our long-term interests.

Banks & financial system
The banks are functioning. But they are weighed down by a lot of bad assets, which are still declining in value. So the banking system as a whole is seriously under water. The amount is difficult to estimate. But I think it’s in the region of maybe $1.5 trillion.

I am afraid that we are basically setting ourselves up on a route which will lead to preserving the banking system, preventing it from collapsing, but not recapitalizing them, but allowing them to earn their way out of the hole. And that is going to weigh on our economy for a considerable length of time and set - instead of providing new energy in terms of new loans, it will actually sap our energies by the banks charging heavy fees and restricting credit in order to improve their own earnings, in order to first of all survive so they don’t have to put themselves into hands of the government; and if possible, to buy themselves out by repaying the loans that they have got.

HSBC just raised $18.5 billion and I also subscribed.

On when to cut losses
If it isn’t working, I re-examine it. And it depends on the re-examination. It may be that I find nothing wrong and I can explain why its not working the way it’s supposed to. And I might actually increase my position. Or, I discover something that I left out of account,
and then I cut my loss. So - and I don’t cut my losses automatically. And sometimes, actually, I greatly increase my positions because the - I find the situation more attractive.

INTERVIEWER: So you still do your analysis and just - even if it’s going against you for a while, if the argument that got you there still working, you stick with it?

SOROS: Yes, yes.

Has the rally got legs?
I think it’s a bear market rally because we have not yet turned the economy around. What people don’t seem to understand, that something quite profound has happened. It doesn’t happen very often that the financial system actually collapses. So this is not a financial crisis like all the other financial crises that we have experienced in our lifetime.

The US Dollar's role as reserve currency
To some extent it has already been replaced because it’s not the sole reserve currency anymore. The euro is an important alternative. But there aren’t other alternatives. And the special drawing rights, which I think is a very good thing to use for other reasons, is not an alternative currency. Those are merely bookkeeping entries at the IMF. They can’t be used to buy goods. You know, to use them that way, you have to convert them into useable currency.

US fiscal deficit
You are not going to have a widening U.S. deficit, because there isn’t any more the desire to finance those deficits. And we are not in a – the households are not in a position to use the appreciating house values to savings. And so the savings rate of U.S. households will increase substantially. So the deficit is already falling, and it will continue to fall. So we will actually get back into closer to balance than we were. That’s not a very optimistic view because it’s very painful because it means that we are - economy will not grow that much.

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.

Bear or bull market rally, you decide

The debate on whether this is a bear market rally or the foundations of a bull market goes on but I thought it would be interesting to consider some of the facts given that, relative to the change in fundamentals, the market recovery appears somewhat excessive.

Last week's economic numbers were in general appalling and the rate of change continued to decline. The chart below shows year-on-year industrial production numbers for Jan & Feb. I have focussed on industrial production numbers because all of the major countries released figures in the last 7 days so they are a good basis for comparison.

This compares to equity market performance over the last 6 trading days shown below...

Caught between a rock and a hard place

Shareholders are caught between between dividend cuts and rights issues in what is effectively a liquidity squeeze. As if reduced cash flows from dividends wasn't bad enough, investors are also being asked to cough up more cash by companies issuing new shares.

In the UK alone, Threadneedle forecast £50 billion of equity issuance by UK companies 2009, more than double the £23 billion issued in 2008.

The outlook for dividends is equally bleak. Standard & Poor’s forecasts the worst year for dividend cuts since 1938 for US investors. S&P forecast dividend pay-outs for 2009 to drop at least 22.6%, since cash flow is crucial for companies and their need to conserve cash will outweigh their desire to pay dividends.

Moreover, having principally affected financials, who were responsible for £16.9 billion of the total £23 billion raised from rights issues in the UK in 2008, the list of sectors issuing new shares and slashing dividends has grown considerably in 2009. Indeed, BP, whose dividends accounted for over 11% of the total dividends paid by FTSE All Share companies, is expected to freeze its dividend this year for the first time since 1999.

Investor appetite for forthcoming rights issues is likely to be severely tested. Indeed, following another new low in equity prices, investors will be wondering whether they should throw yet more good money after bad. Indeed, the investment banks who are underwriting the rights issues are charging 50% more in fees to compensate them for the risk of being left with a large rump in volatile markets.

Banking on dividend cuts

Following the recent dividend cuts from financials such as HSBC and JP Morgan, who have cut their dividends by more than 80%, the forward looking yield on major equity indices is likely to be reduced significantly due to the large weighting of financials within these indices. For example, financials make up 30% of the €Stoxx 50 index and they contribute circa 50% and 30% of the index's historic and projected yield. Whilst this suggests that the market has already factored in dividend cuts, any further cuts, of say 50%, could reduce the index's dividend yield by 1%, from 6.5% to 5.5%.