Business Times - 26 Aug 2009
The six-month stock rally looks likely to continue but the risks have risen sharply along with prices, writes LIM SAY BOON
INVESTORS who have yet to hedge their equities positions - something that is always important to do for long-term portfolios - should look into this pretty quickly. On balance, the stock rally of the past six months should continue. But the risks have risen sharply along with prices.
The recent 20 per cent correction in stock prices on the Shanghai stock exchange might not have marked the end of the rally. But it is a warning shot. More than that, it was probably also a glimpse into the future - at how the cyclical rebound in the equities markets could end.
This has not been a high-quality rally. The underlying recovery in the global economy has been driven by inventory restocking and government fiscal and monetary stimulus. Meanwhile, the markets for risky assets - stocks, corporate debt, and commodities - have been helped along by a huge amount of liquidity sitting on the sidelines, in bank deposits and money market funds. The 'frightened money' appears to have started re-entering the market, with bets in favour of government intervention trumping deflation (see Chart 1).
But what happens after the 'mechanical' business of inventory restocking runs its course? The US consumer has been weakened by a one-third decline in the average home price and frightened by employment approaching 10 per cent. There must be serious questions over the ability of the US consumer to sustain the economic recovery beyond inventory restocking.
And even more importantly, as the panic of the past two weeks over Chinese stocks has shown, this is a monetary stimulus-dependent rally. On speculation that the Chinese government might start pulling back money supply and credit growth, the Shanghai stock market collapsed. This is not surprising given the correlation between money supply growth and the performance of the Shanghai Composite Index (see Chart 2).
But this is not just a Chinese market phenomenon. Monetary stimulus - cheap money and plenty of it - has been crucial in sustaining the 'wassail on Wall Street' (and elsewhere). The markets understand this. So they are closely scrutinising almost every word from central bankers around the world for hints of imminent 'exit'.
Events of the past 12 months have been tagged 'the Great Recession meets the Great Government Intervention'. On many measures, the 'Great Government Intervention' has prevailed. The global economy is already in recovery. Economies from Germany to Japan to Singapore are out of recession. The US is likely to be confirmed in coming months as having emerged from recession in Q3 2009.
Asset price performance
Going forward, three factors will be crucial to the future of the ongoing recovery in risky asset prices. The first relates to the strength of the cyclical rebound in the global economy. The second is about growth drivers beyond inventory restocking. And the third relates to the eventual unwinding of government stimulus.
There is a serious risk of disappointment in the strength of the economic rebound in coming months. To date, the economic data has been weighted in favour of performances beating market consensus. The equities bulls appear to be betting on the continuation of better-than-expected data.
That is, they are counting on a sharp rebound following the deep decline of the past 18 months. They are betting on the mechanical process of recovery from sharp inventory destocking, further supported by aggressive government stimulus.
However, recoveries from recessions associated with financial crises have tended to be weaker than those from simple 'cyclical recessions'.
Meanwhile, in the US, unemployment is approaching 10 per cent, house prices are down by an average of around 33 per cent, and the US household savings rate had surged from almost zero savings to around 6.2 per cent of disposable income at its recent high (before pulling back more recently to 4.6 per cent). If this marks a 'new frugality' among US consumers, the global economy is going to struggle to find new drivers for growth.
And if governments start withdrawing fiscal and monetary stimulus while the world is still fumbling around for a new growth paradigm, that would almost certainly trigger a sharp correction in the rally in stocks, corporate bonds, commodities, and commodity currencies. At this stage of the recovery, the stimulus is the party 'punchbowl'. Take that away and the party ends.
On balance, central bankers are likely to be very circumspect about withdrawing stimulus. In the US, looking back some 40 years, the Federal Reserve has never raised its policy rate until the decline in the unemployment rate has been unambiguously entrenched.
That has meant a lag of months, even a year, after the peaking of unemployment. In China, there has been a tendency by the Chinese government over recent cycles to pull in money supply growth only during peaks or close to peaks of industrial production and export growth.
Currently, US unemployment has only just shown very early signs of peaking. Meanwhile, in China, exports are still in deep year-on-year contraction. And with prices in deflation, there is little incentive at this stage for the Chinese government to reverse course on monetary policy.
So money is likely to continue to be plentiful and cheap. Low interest rates are likely to continue forcing investors into the risky asset markets in search of higher returns. And late-comers to the rally could push the markets into an overshoot of fundamentals.
For example, the Shanghai Composite prior to the recent correction was trading at 3.8 times book value. And even with the correction, it is still trading at around 3.6 times book. Eventually, when earnings growth kicks back in, the focus will turn to price-earnings valuations and high returns on equity will eventually justify the high price-to-book valuations. But this has not happened yet - hence the 'overshoot' of fundamentals.
Prices for risky assets are likely to push higher, notwithstanding all the unresolved fundamental problems. But the easy money has been made. Prepare for a rougher ride from here. Volatility - measured by the S&P 500 volatility index VIX - recently hit a low of around 23 per cent. It is still trading around 25 per cent, a far cry from its crisis peak of 90 per cent. Volatility is cheap. Investors should consider buying a proxy for VIX (see Chart 3).
The less aggressive investor might want to start taking profits off the table while continuing to ride this liquidity rally. They might put those profits into VIX to hedge their equities portfolios. They might also want to consider low correlation plays such as gold.
Lim Say Boon is the chief investment strategist for Standard Chartered Group Wealth Management and Standard Chartered Private Bank
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