THERE comes a time in the life of a mature bull market when positive economic shocks are required to sustain momentum. The trouble with 2016 is that the shocks have been mainly negative, with the result that equities and other risky assets have reacquainted themselves with the laws of gravity. Since the start of the month volatility has been the order of the day.
The biggest scare story has been about slowing global growth and the fear of a crash landing in China and other emerging economies. The experience of last August, with the bungled devaluation of the renminbi and botched attempt to bail out the Chinese equity market, has been repeated this January, but with increased concern that further devaluation could precipitate a fresh round of currency warfare.
Investors have also worried that China’s transition to a consumption-based growth model is proving more difficult than expected, with spiralling debt and the rickety balance sheets of state-owned enterprises.
In the US investors are worried about decelerating corporate earnings and fear that the Federal Reserve’s tighter policy will push the economy into recession. As for Europe the structural problems of a monetary union that lacks the fiscal and financial infrastructure to sustain a single currency continue to nag, while growth appears overdependent on the conjuring skills of Mario Draghi, president of the European Central Bank.
In the US, investors are worried about decelerating corporate earnings and fear that the Federal Reserve’s tighter policy will push the economy into recession
Looming over this neurasthenic combination is a plethora of geopolitical risks that seem more pressing than in any year since the financial crisis.
In the echo chamber of Davos business leaders will no doubt whip themselves into a state of fevered anxiety and risk aversion as they contemplate these worries, remote from the real world. Yet it is not difficult to make a case that pessimism in the markets is overdone.
China’s transition away from an excessive export and investment orientation is making progress. The service economy is growing faster than manufacturing. According to the Institute for International Finance, a club of big banks, service industries accounted for 40.3pc of foreign direct investment in the first 10 months of 2015, compared with 30.7pc for the whole of 2014.
Beijing’s response last year to the economic slowdown was to resort to aggressive monetary and fiscal easing, together with a return to increased public investment and requests to the banks to roll over loans to zombie manufacturers.
That suggests that the Chinese economy is unlikely to be a destabilising force in the world in 2016 and that there may even be a little relief for EM commodity exporters, although it also points to a brake on structural reform and a greater pile of debt down the road.
In the US and Europe — leaving aside energy companies — there has been a substantial positive economic shock in the shape of the oil price collapse. This transfers income from oil producers to consumers in the developed world, who are busy spending the windfall. Consumer industries and especially the car industry have felt the benefit.
Yet there is not enough here to reassure markets, for the various negative shocks have exposed an uncomfortable reality. Since the central banks embarked on their unconventional measures, inflated market valuations have been supported by an increasingly threadbare income base.
This is especially true of bonds, some of which, in the eurozone, offer negative nominal yields. But it is also true of equities, where there is the added vulnerability of potential dividend cuts. And increases in capital values in the equity market have latterly been heavily dependent on a handful of trendy technology companies and on smaller companies.
What experience in both the US and China confirms, in different ways, is that rigged markets are inherently vulnerable, particularly when central bankers withdraw from the fray. The good news is that markets no longer dance in lockstep to the central bankers’ tune.
Monetary policies no longer lift all boats. So there is divergence in markets as well as in monetary policy. The result is that more opportunities are emerging to tempt those with strong nerves. For contrarian investors there is life, at last, after a near-death experience.
Published in Dawn, Business & Finance weekly, January 25th, 2016
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