The bull is rolling over

SPX falling out of bullish channel, closing below 1,060 suggests weakness to come. SELL!!

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.

Why have bond and equity markets been rallying in tandem?

The answer is simple. Equities have rallied BECAUSE bond yields have fallen, reducing the cost of capital and forcing investors to take more risk to maintain their yield. This amounts to a universal carry trade driving everything including corporate bonds, equities and currencies.

Moreover, the fall in long bond yields is being driven by the short end, on which they are anchored. So, as the 2 year yield is squeezed lower by FSA liquidity requirements and lower for longer base rates, longer dated yield shave also benefited from the carry offered by the steepest yield curve in over 20 years. This interplay is demonstrated by the 2's 10's spread, which has remained stable, as the 2 year has hit a record low...

Anatomy of a liquidity trap

Liquidity trap: A situation in which prevailing interest rates are low and savings rates are high. As a result, monetary policy is ineffective.

The effectiveness of QE is being compromised by unwillingness on behalf of UK banks to lend. As a result, for every £1 spent on QE, less than £1 is being lent out, which means banks are hoarding the money in order to bolster their balance sheets. This is clearly demonstrated in the charts below, which are based on weekly data from the Bank of England. The first chart shows how a large part of the BoE's ballooning balance sheet has come from reserve balances. The second chart suggests that the cumulative Gilt purchases by the Bank of England have been responsible for the increase in commercial bank reserve balances held at the Bank.


Having initially been about increasing “the amount of money that’s held by the wider economy”, the purpose of QE has been refined by the Bank of England to restoring M4 (ex Intermediate OFCs) growth to 5% per annum. Therefore, the Bank of England acknowledged in the August Inflation Report that QE is not meeting their 5% target:

One potentially useful diagnostic of the impact of the Bank’s asset purchases is the extent to which they boost the stock of broad money. Broad money growth remained weak in Q2. That reflected continued underlying weakness in nominal demand: nominal GDP fell by 3% in Q1, and is likely to have fallen further in Q2. Absent asset purchases, it is likely that money growth would have been even weaker.

Indeed, despite QE, M4 is moving further away from their target...

Given the ineffectiveness of circa £150 billion of Gilt purchases to date, speculation is mounting that the Bank will resort to increasing the QE programme to £200 billion and charging negative interest rates on reserve balances at the BoE in order to boost the money supply and force banks to lend. This, coupled Mervyn King's prognosis of a "slow and protracted recovery", explains why yesterday the two year Gilt yield reached an all time low of 0.74%, Cable sold off two big figures and interest rate futures are pricing in low interest rates will continue for the foreseeable future…

Let's party like it's 2009!

The recovery party is in full swing, fuelled by an enormous punch bowl of monetary and fiscal stimulus. Having initially threatened to call time by discussing exit strategies, the G20 has agreed to leave the stimulus in place. In doing so, the world's finance ministers have unilaterally committed to underwrite the economic recovery.

Thus, cheap money has increased the price of everything from oil to stocks. Furthermore, in the short term the rally has become a self perpetuating virtuous circle, pushing sentiment indicators higher which in turn sustain further gains. However, easy money and sentiment can only take markets so far. In the end, unless they are supported by above consensus earnings, GDP and clear signs of demand, markets will falter.

Indeed, beneath the benign exterior of lower for longer interest rates lurks a liquidity trap and an economy delicately poised on a knife edge (more on both of these to come).

It is usually sensible to leave a party while it is still in full swing.

China, the engine of global growth or a bubble in the making?

The case for
Chinese GDP in the second quarter was a whopping +14.6% p.a., contributing 1.6% to global GDP, which without China would have been flat.

The surge in the copper price and the fall in the US Dollar are testament to the fact that China has become an undisputed key force in many markets. If China is the engine of global GDP then its demand for materials and assets will drive global asset prices higher.

The case against
Chinese economic data and its method of calculation is questionable (e.g. goods count as having been sold when shipped to retailers, not when purchased by consumers). Furthermore, the latest set of first-half GDP numbers from provincial authorities are far higher than Beijing’s national figure, raising questions on the accuracy of statistics.

The current liquidity boom is reminiscent of the US from 2000 to 2007, with cheap money fuelling asset price bubbles. Loan growth is unsustainable and instead of being deployed strategically, must have been used speculatively judging by the rally in the real estate prices and the Shanghai Composite index (+80% year to date!). The Shanghai Composite index trades on 24 times forward earnings, which is 41% premium to the S&P 500, which trades on 17 times expected earnings.

Other evidence of a bubble can be found in recent Chinese IPOs. China State Construction Engineering Corp smashed IPO records, raising 50.2 billion yuan (or 43x recorded earnings) and was up 56% in its first day's trading! When a market is that 'hot' it is either fuelled by retail demand or a sign of far too much easy money chasing too few good investments opportunities. Both signal overvaluation and impending correction. As every tech bubble veteran knows, the hotter they are, the harder they fall.

Finally, as if all of the above was not bad enough, Chinese asset prices appear to be under the control of the country's government who themselves admit that fresh asset bubbles are forming. On Wednesday 29th July the Chinese equity market fell 7% on news that the government would restrict the amount of bank lending. Realising the impact of their announcement, the following day the government announced it would 'unswervingly continue to apply appropriate loose monetary policy' and stocks recovered the previous day's losses. For this reason alone, Chinese equities deserve a higher risk premium since they are vulnerable to government intervention. Although, so are most Western markets.

Conclusion
In the long term China will undoubtedly become an engine of future global growth. However, in the short term, investors in Chinese assets have got ahead of themselves and allowed prices to go too far, whilst ignoring the risks associated with a torrent of liquidity. If left unchecked, such aggressive stimulus risks bursting what is now a bubble, as Nouriel Roubini notes in a recent post on his blog:

Aggressive government led stimulus (direct government investment and encouraging banks to lend) contributed to a reacceleration of growth in Q2 2009, one of the first countries to have a growth acceleration in H1 2009. While upside risk is certainly present for China's GDP growth outlook, serious downside risks from China's fiscal and monetary expansion remain. In particular the risks that stimulus is contributing to asset bubbles in property and equity markets, worsening the risk of non-performing loans and adding to overcapacity could, especially in the absence of a rebound of external demand contribute to weaker than trend growth in 2010-11.

Asian Development Bank predicts Asia ex Japan GDP to recover to pre recession level of 6% in 2010...

... however, it is too early to declare V for victory. Governments have substituted public investment for private investment and exports that have evaporated. With Western demand unlikely to pick up the slack, 6% GDP must come from domestic demand, which is unlikely. The ADB report shows that Asian demand, including China, accounts for 22% of demand for Asian exports. Moreover, H1 Chinese imports fell -25%. So, until Asian economies can create sustainable domestic demand, their recovery will remain fragile.