Anxiety is growing among investors that equity markets may be headed for another plunge as governments grapple with how to reduce budget deficits and repay government debt.
The US Federal Reserve’s so-called quantitative easing (QE) stimulus programme was meant to stimulate consumer demand, but instead much of it may have gone into risk assets such as commodities and global equity markets. The Fed’s $600 billion programme to buy Treasury debt has helped investors divert funds to commodities and equities, creating a bubble in those assets, which is now starting to burst.
The most positive view is that the ending of the Fed’s QE2 programme will prompt a modest 10% decline in US equities — which is what happened at the end of the first round of Fed buying.
However, the chief protagonist of the W-shaped recovery has all along been Dr Nouriel Roubini who warned more than 18 months ago of the “high probability“ of a second leg of the recession, an “outside chance” of a U-shaped recovery and only a “20% chance” of a V-shaped recovery.
He argues that actions such as QE by the US government and bailouts in Europe are only delaying the inevitable. His words are not taken lightly, because Roubini is most famous for having predicted the 2007/8 recession.
Recently, the US bears have been interpreting several economic indicators as the start. Commodities have been at the forefront of the selling so far, as May saw an end to the big rallies in hard assets. Gold has dropped slightly, while silver crashed 30% in its worst fall since 1980. Oil, which was until recently worrying investors with its sharp ascent, fell around 15%. Copper, known as the ‘metal with a PhD‘ for its ability to act as a predictor for the economy given its wide-scale industrial applications, hit a five-month low. The growing concern is that stocks have priced in an overly optimistic economic path.
PIGS hog the debt trough
Dominated by global debt levels, primarily in the PIGS countries (Portugal, Ireland, Greece and Spain), but also the US budget deficit, David Gracie, of Investec Bank, says, “there is a lot of tension because the market does not see how these debts are going to be paid off.”
A year and a half ago Roubini said that one of the most crucial questions to be faced will be the timing of the exit strategy from various stimulus measures. “Those policies were necessary to avoid an actual depression, but if kept too long raise the danger that large budget deficits will lead to renewed inflation and recession,” he said.
These policies are still in place. The challenge for governments is to create a self-sustaining recovery, says Gracie, but until then they are committed to stimulating global demand. This also limits their ability to reduce budget deficits.
Rob Porter, Standard Bank director and head of Foreign Exchange Sales, says: “Renewed concerns about the lingering sovereign debt crises in Europe best explain the pullback in the euro, and as the dollar recovered, the speculative element in the commodity market started to reverse. At this stage it is difficult to determine whether early May’s sudden correction will be sustained. However, if the Fed starts adopting a more hawkish tone over the coming months, then we would also expect the dollar recovery to continue and for commodity prices to correct further.”
Nothing here to scare investors off
Craig Pheiffer, general manager: Absa Investments, rejects the idea that stocks are pricing in an overly optimistic economic path — in South Africa at least.
“Absa’s view is that there will not be a double dip. Granted, one cannot discount the many risks, especially the European debt crisis, but with a global average of 4,1% GDP growth expected this year, followed by 4,5% next, the future valuations of global exchanges don’t seem as expensive as they were. The JSE still has some upward momentum left in it as average earnings of about 25% are expected to come through.
“For instance, the increased valuations of commodity companies come off a very low base and though they doubled last year there is still some substantial growth left in them as good earnings come through,” explains Pheiffer.
What is causing investors in the US to jump out of risk investments is “the huge speculative element lying on top of their markets, which is pushing prices up and down. Absa expects the average annual prices of the top six commodities to be higher this year than last, and higher next year than this.
“So any collapse of stock markets may be a combination of the withdrawal of stimulus measures and the withdrawal of that speculative element — but there will still be other support measures in place and governments will ensure the withdrawal is done at a measured pace.
“A 10% pullback in equity prices is possible under these conditions but a dramatic collapse in the market is not the base case scenario,” he adds.