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Actually, the bad news comes later

WorldWatch
2 May 2012

With the spring rally over, investors everywhere are asking whether this is a pause or the beginning of something darker. The recovery is losing momentum. European sovereign debt is a growing worry. But in the big picture tail risks are much reduced, and that means limited downside.

Look to the West: government stimulus is in question; Greece, Spain & Portugal are car crashes waiting to happen, and companies everywhere are too nervous to invest. Look to the East: India is adrift; North Korea has broken loose, and in China the political system is boiling over.

Is it any wonder that asset markets are worried?

But is it more than a pause? That depends on how much depth there is to the many concerns that are weighing on investors this spring. Let’s identify the key concerns, and put them to the test.

There are three big issues on the table, and conveniently they span the globe: the US, Europe, and China. The big worry is that one or a combination of these confidence-killers is set to start driving markets down way beyond the current correction level. The spectre is of a repeat of last year, when poor data and the threat of worse from Europe spooked rallying markets and turned a promising year into a poor one.

Is the US recovery sustainable?

We have had a strong quarter of improving data, with jobs, confidence and spending up. But now the momentum of improvement is waning. Real unemployment is static; retail sales are growing, but without a great deal of vigour; house prices are not moving. Add to all this a nervousness about the appetite for further stimulus: the latest FED minutes show that the bar for QE3 is higher than previously thought – the economy has to get worse from here to trigger further stimulus.

How bad is this data flow? On balance, it is suggestive of pause. For now the movement is sideways, with negatives offset by positives. The most important factor is that the safety net is still in place: if the data start to deteriorate, QE3 will be back on the table double quick.

US Initial Jobless Claims

Trending below long-term average

us initial jobs claims trending below long-term average

Source: BLS, NBER

Is European sovereign debt going to turn around and bite again?

Last year Greece, this year Greece and Spain. With all eyes on Greece, let’s not forget that Spain is a much bigger fish. Spain’s private and public sector indebtedness is higher than at first calculated, a fact that credit markets are only now digesting. Official debt is heading towards 100% of GDP as government absorbs the costs of cleaning up the private financial sector, while private debt is well over 160% of GDP even as incomes are falling. The chances of stabilising what is still a deteriorating debt situation and returning Spain to growth through some as-yet-unspecified supply-side reforms is now seen by markets as close to zero.

Last year investors feared that the euro currency system was about to break up and that the European financial system was on the verge of systemic collapse. Better policy coordination and ECB intervention have removed a lot of that tail risk. 

But the prospect of a disorderly Greek exit from the eurozone – a ‘Grexit’ – has altered the equation. As last year, a policy solution is to hand – but things probably have to get quite a lot worse to trigger it.

Will China finally suffer its long-delayed and much-discussed ‘hard landing’?

China’s underlying challenges are well-known: the banking sector is a very large and only partly regulated space that is suspected to harbour a lot of effectively non-performing debt; the total economy is 50% dependent on fixed asset investment, in a world where demand is not growing; there is a housing bubble. With growth falling – first quarter at 8.1% and likely to fall further – these challenges start to become acute. China is facing the final phase of an export/investment-led boom, and that is usually not a pretty phase.

But the investment implications are not so bleak. As Chinese growth eases, the likelihood increases of monetary policy turning stimulative again. This is the China ‘sweet spot’, where bad news is good news for asset markets. Indeed, there are already signs of policy being pointed towards consumer credit growth and higher wages. But it is coming at a political cost: the recent ‘purging’ of regional party boss Bo Xilai seems to suggest that political conflicts over whether and how to normalise the economy are running very hot.

Equities Seriously Under Owned

Bond vs equity mutual fund flows

bond vs equity mutual fund flows

Source: EPFR Global/JP Morgan Cazenove

None of these big questions – the US, Europe, and China – are resolved. But the risks they imply are not as alarming as they once were. Both the US and Europe have a clear backstop if the data flow turns seriously negative, or if the southern Europe financial crisis turns disorderly; China has probably smoothed the path to political transition later this year. And equities are cheap and under-owned.

Longer-term, there are even bigger issues to be confronted. In the developed economies private deleveraging, public austerity, and overall low growth will predominate. In the emerging market world there are some tough times ahead too, above all for China. There has never been an investment boom on a Chinese scale without a subsequent bust. Managing that transition will impose strains that everyone will feel.


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