FYI | Jun 01 2006
By Greg Peel
FN Arena has reported on various risk measurements and their collapses in the last week or two, and in each case these have provoked the offering of various opinions. Why has risk appetite collapsed? Inflation fears? Fear of an economic slowdown? Overstretched markets? To complicate matters, each factor is interconnected with the others.
The question we would like to know is, however: where to from here? And that’s when its gets tricky.
It is agreed that an unexpected US CPI figure for April was the catalyst for the first wave of selling. It is not agreed that inflation fears have been the sole cause of the ongoing correction, however. If anything, economists are not overly concerned about inflation. They tend to agree that fears of an economic slowdown are the major impetus.
Credit Suisse’s risk index collapsed. The analysts do believe that core inflation is picking up, which does not bode well for commodities and equities, but CS believes global economic growth is slowing, which will put a cap on inflation growth. Conclusion: a further shakeout in risk assets until towards the end of this year when things should pick up again. This is predicated on economic growth slowing.
Merrill Lynch’s risk index collapsed. Merrills is predicting a slowdown in economic growth but notes credit is still reasonably freely available, so any slowdown will be benign. A continuing of central bank tightening will leave riskier assets looking overvalued, so the analysts suggest a move to a balanced portfolio of core assets with steady (not explosive) earnings growth. Conclusion: avoid risk for the moment.
Morgan Stanley’s risk index has collapsed. (This is the "another" referred to in the headline). Morgan Stanley economist Joachim Fels ponders whether this is just representative of a profit-taking correction in an otherwise healthy environment (good) or whether it foreshadows a deterioration of the inflation/economic growth outlook (bad). He favours the latter, meaning we could be in for a more sustained move.
Fels believes liquidity has driven the boom, and liquidity is finally starting to shrink. US and ECB rate hikes have seen to that. A drainage of excess liquidity tends to hit those asset classes that are most overvalued. With Japan close to tightening, and the Fed still looking hawkish, we are most likely to see a significant slowdown in economic growth before monetary policy can ease and risky assets can be bought again. Conclusion: The economy will slow all this year and the first half of 2007. Buy bonds and cash.
Fels’ colleague Stephen Roach (yes, he of the fur, claws, and weakness for salmon) doesn’t believe the inflation scare is serious, nor that economic growth fears are extreme. Roach believes the markets have been in a bubble.
While a bubble can be pricked, Roach also points out that a bubble can suffer a point of weakness in its membrane that rapidly spreads until the whole structure implodes on itself. In the great liquidity explosion we have experienced bubbles in equities, bonds, emerging market and credit instruments, property and now commodities. Roach hints that one asset class may bring the rest down as well.
He cites the example of the dotcom burst, where only dotcoms were the weak link, but the whole S&P500 fell 49% over two and a half years after dotcoms imploded. He sees a similar risk of asset contagion today.
Roach does not agree with Fels that liquidity is shrinking. There is still a long way to go to address global imbalance (ie US current account deficit, Roach’s favourite whipping boy) and central banks will have to tread the path carefully. In the meantime there is still room for assets to bubble. The basis for this is also a (misguided, in Roach’s view) belief that global risk has been re-rated forever. Conclusion: it’s not over yet, but look out when it is.
The economists at BCA research dismiss inflation with a scoff, and advise to concentrate on a slowing world economy. BCA believes the Chinese economy has peaked, and that commodity price falls have further to go. Conclusion: sell into rallies.
Merrill Lynch Investment Management (a separate entity) also dismisses inflation and points to slowing economic growth. MLIM sees equity prices under pressure for weeks, or even months. Those asset classes most vulnerable are the most overvalued, ie commodities, emerging markets and small caps. Conclusion: After aforementioned months we will still be in a bull market.
What, then, is the aggregate conclusion? Confusion? Tell me about it. Inflation is not really a scare, but economic growth is expected to slow, so that would cap inflation anyway. But if inflation is a scare, then that would slow economic growth, which would then cap inflation again anyway. The markets are in a bubble that needed to be corrected, and inflation and slower economic growth will see to that bubble being rectified over the next few months, at least into 2007. After that we will probably be in a bull market still, unless there hasn’t been any global rebalancing as a result of slowing economic growth in which case, if you believe Roach, we’re all going to hell in a hand-basket. Economics 101.
Just to give things a little push along, CLSA has just announced it expects a sudden spate of price rises for goods coming out of China as the Chinese have been wearing paper-thin profit margins for too long. Inflation here we come. What happens next?