FYI | Feb 27 2007
By Greg Peel
When all about them were dooming and glooming about a global economic slowdown the lateral thinkers at GaveKal were making a very strong bullish call on global equities, and particularly US equities. Lately, economic data releases are surprising on the upside, and the market is not buying the slowdown talk.
After a negative start to the year, commodities are back in favour, with the Goldman Sachs Commodity Index rallying 11.9% since mid-January, led by a rebound in crude oil and a 14.9% rise in metals bellwether copper. Nickel, steel and other commodities are also rising, which doesn’t sound much like an economic slowdown.
Furthermore, cyclical equities – those which tend to rise and fall with economic strength and weakness, are strong. Within the S&P 1200 index of global equities, strength has been found in the materials sector (up 8.5% year-to-date) and in consumer discretionary (4.4%).
GaveKal also notes the Aussie and Kiwi dollars have been gaining against the US dollar, by 1.9% and 2.6% respectively this month, making them two of the best performing major currencies. Says GaveKal: “As most investors know, the Aussie and the Kiwi are usually both correlated to global economic growth”. To top things off, the Australian share market is up 6.5% for the year.
GaveKal’s equity call has been predicated on a global appetite for risk. It is on that score, however, where things are beginning to look different.
GaveKal notes sub-prime mortgage lenders in the US are in trouble. Since the start of 2006, 20 sub-prime lenders have shut down, scaled back or sold themselves to larger outfits. Sub-prime make up 13.5% of outstanding US mortgages, so this development is not inconsequential.
Six weeks ago, a credit-default swap index of 20 securities rated BBB was launched to allow investors to acquire insurance against defaults. The value of that index has now dropped by 30%, meaning that insurance for a US$10m bond portfolio will cost US$1.25m per year to cover, as opposed to US$389,000 when the index was launched. If insurance is becoming expensive, should we see a move towards less risky assets?
The evidence would suggest so, notes GaveKal. Gold futures are up 12.9% since January 5 to the highest level since last May. This could reflect Chinese New Year buying, concerns over Iran, or a more simple movement into risk protection. Long bonds are also rallying again, with the US ten-year yield falling to 4.68% – the lowest level since January 9.
The Indian stock market – a bull market leader of the last few years – tanked 2.8% on Friday. India is now the worst performing equity market in Asia in 2007.
As risky assets have had a very good run over the past six months, oil seems to be breaking back up, and central banks seem “in no mood to cut rates”, GaveKal feels it may have to “rein in” its very bullish stance.
Given that the liquidity surge of the past few years has come from the private sector multiplying what is actually shrinking primary liquidity, the sort of returns we’ve been enjoying would not be sustainable should the secondary liquidity dry up. Credit spreads remain tight at present, real rates are low and volatility is low. If this stays the case, markets will be okay.
“However, we fear that in the coming weeks, one of these variables could change.”