FYI | May 26 2006
By Rudi Filapek-Vandyck
The current market jitters have not so much to do with an overall turn in sentiment, but more so with the large amount of margin calls being made and speculative positions that are leaving the arena. That is if you happen to believe ANZ Bank’s currency strategist Tony Morriss.
We would be inclined to think that investment strategists at Credit Suisse and Merrill Lynch do not subscribe to Morriss’ view. But then again, there are some merits to this opinion as the newly renamed and officially launched (as of today) Australian Bear/Bull Indicator signals the underlying sentiment as expressed by investment ratings on individual ASX-listed stocks by ten leading experts is still in Red Hot territory. The number of Neutral recommendations is moving away from the 50% again, but very slowly.
This is, of course, more than just a temporary scare and the swift reversals of risk appetite indices at Credit Suisse and Merrill Lynch are living proof of that. If the old adage that it takes three times longer to build up confidence than to loose it has any merit it will take some time to reinstall the market’s confidence. So expect more ups and downs in the short term and volatility, probably a lot more volatility than we have been experiencing over the months prior to the May correction.
The world is coming to grips with the end of a golden era and the transition brings along many uncertainties and insecurities. Is inflation really the new enemy? Many commentators don’t believe it is. So what is the problem then? Well for starters, we don’t really yet know whether inflation will destroy the party. Some think it won’t, but there is absolutely no 100% guarantee it won’t. We need more time to fully assess this and there will be some conflicting signals and analyses along the way.
Of more importance, probably, is the fact that the world economy is losing its two main engines: the US consumer and the Chinese export industry. Isn’t this what Stephen Roach at Morgan Stanley has been warning of? Yes, he has, for two years now and it all seems to be becoming reality in 2006. Given the importance of the two over the past few years, it is more than understandable investors have become more risk averse over the past few weeks –whether the unwinding of massively built up speculative positions is the cause or one of the side-effects remains open for public debate.
Well regarded China watchers at CLSA published a report this month in which they stated Chinese growth could fall as low as 5% in the medium term. At a time like this, when many investors are questioning the large exposure to China and commodities in their investment portfolios, this is not exactly the news they want to hear right now.
It wasn’t that long ago that the new Chairman of the Federal Reserve Bank scared the market by implying the Fed wasn’t giving up on the possible need for higher interest rates just yet. It is the possible cause behind such a decision that is now receiving full market attention. If economic growth is slowing the need for further central bank tightening will diminish, but does that make slower growth positive in itself?
The relationship between inflation, interest rates, bond yields and economic growth has taken the markets in a firm grip. All of a sudden, the goldilocks scenario has come crashing down, leaving questions galore with only a few firm answers.
Experts at independent research house BCA Research called it The Tug Of War this week. BCA is not worried about inflation, the experts have been arguing against it for many months now. And they predicted the world’s attention would shift to global growth once investors get over the initial inflation scare.
BCA would advise investors to sell into any short term rallies on share markets – because the economic slow down is for real, and inflation is not. BCA is particularly cautious with regards to metals and other commodities. That is because the Chinese economy has peaked in its view and the road ahead is for less growth as well as for more measures by the Chinese authorities to stem some of the internal problems.
As metals markets remain overbought, even after this month’s fierce correction, BCA believes we have yet to see "significant weakness" kicking in, even though the Chinese slow down is expected to occur gradually. What goes for the metals goes for most other commodities as well, by the way.
Look through the clouds and what you’ll see is that profit margins for most listed companies are still above their historical trend. This is good news and in combination with contracting price earnings ratio’s (PER) this should provide equity markets with a solid platform to rebound. But what if slowing economic growth starts impacting on these margins?
Well, that is the big question for the longer term, isn’t it? First we will all experience the end to further Fed tightening, the bond markets turn more benign and the inflation scare ebb away (all under a positive scenario).
Once we get past that point we will see a still positive economic environment and companies enjoying relatively large profit margins. It is for this reason that strategists at UBS confidently predict share prices will be higher than today over a six to twelve month time frame.
At BCA, the experts seem a little less confident about this scenario. They believe the conflicting trends in global finance will have a rather ambiguous impact on share markets. On one hand, slower economic growth will put pressure on profit margins, this is bad for shares. On the other hand, no more interest rate hikes is a positive.
It’s this Tug of War between slower growth and the downshift in global interest rate expectations that will define the pattern in share prices over the next few months, BCA says. Meanwhile, the short term outlook would appear bullish for bonds and bearish for equities, especially the more risky ones. That includes resources and emerging markets.