Australia | May 20 2010
By Greg Peel
As at yesterday's close the ASX 200 is down 12.3% from its closing price peak of 5001 made on April 15. At that point all seemed rosy. Earnings forecasts for FY11 were solid, the Greek problem seemed to have been resolved, and a level of complacency descended which matched the low point of the US VIX volatility index (an indirect measure of fear) at 15. While China was tightening monetary policy, it was comforting to know this was only an attempt to rein in runaway 12% GDP growth.
Realistically, the world made exactly the same mistake it made in March 2008 – the point at which Bear Stearns was “rescued”. Wall Street declared the credit crisis over, and sceptical views were dismissed. Stock markets began a 50% retracement of their falls to that point.
We all know what happened next.
2010 has been playing out in an eerily similar fashion, albeit in a more rapid time frame. The first announced Greek bail-out package (E35bn) was seen as the end to a minor problem and markets resumed their rally. But it didn't work. Next came a new E110bn Greek rescue package and finally a E720bn pan-eurozone rescue package which I have dubbed the “eurotarp”. No doubt the EU was anxious not to ignore the lessons of the ultimate Lehman Bros demise – the contagion effect.
For the average Australian investor, warning bells were ringing. If we had not just been through a GFC, most likely we would not have seen quite the reaction in stock markets of the past month. Those small investors without expert knowledge in the intricacies of global sovereign debt markets – the same investors who to this day still don't quite understand collateral debt obligations on subprime mortgages – could think of nothing but “Oh my God, I've seen this movie before”.
And that fear is not simply limited to the less-experienced. While the euro-yen exchange rate is oft noted as the explicit fear indicator, immediate impacts are also felt by the Aussie dollar and the Aussie stock market. Japanese investors like borrowing low interest rate yen and buying high interest rate Aussie bonds, while US funds like borrowing low interest rate dollars and investing in Aussie resource and banking stocks, as well as others. If the Aussie market and the Aussie dollar both rise, Americans win twice. But such investments are only made while fear levels are subdued and risk is coveted. Australia is somewhat seen as a safe proxy emerging market investment.
As soon has fear reemerges however, offshore investment monies are rapidly repatriated. And offshore investors are also fearful of the deja vu concept.
But while Europe has dominated the headlines, just about every other bit of news both internationally and locally (with the possible exception of some stronger US economic data) has been negative.
We started with the fraud allegations against Goldman Sachs, which hit our own banks on fear of what regulatory ramifications might follow. Then the Big Four Aussie banks reported earnings and analysts realised the picture was not as rosy as it had earlier appeared. There were headwinds building for the local banking sector.
And then came the RSPT. While it has always been my belief that the Rudd government has deliberately offered a worse case scenario straight up, with expectations it would water the bill down to please the mining lobby but still end up with something resembling what the government wanted in the first place, it is clear Rudd has badly misread popular opinion. No doubt he thought it would be simple to sell a “tax on greedy miners” to the electorate. But while threats to withdraw projects etc are to be expected from miners as part of the lobby process, it seems the general public has not taken to the tax at all.
And given the tax, and the Budget, are based on assumptions of ever rising commodity prices, the fact commodity prices have been tanking this past week or more hardly helps either. Commodity prices are tanking because (a) the US dollar has rallied as the euro falls, (b) Europe's economic growth will now be stunted and Europe is China's biggest export customer, and (c) China is the world's biggest buyer of commodities which it uses to manufacture export goods. And Australia is one of its primary sources.
The risk is that Chinese commodity demand will now drop off, and drop off at a time when Beijing is deliberately trying to tip over the Chinese property and stock markets and reduce economic growth. Will China now put monetary policy plans on hold? Any further tightening will only be another kick in the guts for global sentiment.
Then this week Germany has banned naked short-selling of certain instruments, which might have justification in principal but is ill-founded in timing. It's just another factor which leads investors to believe they might be reliving 2008.
And lastly, let's not forget either the volcano in Iceland, which is still erupting but only disturbs flight paths depending on wind direction, and the oil spill in the Gulf, which remains unresolved.
It is quite staggering how one day everything looked great and the next day every single thing looked bad. And that's irrespective of a widely held belief that stock markets need a healthy correction anyway.
So is this the “healthy” correction?
It would be foolish to dismiss the European situation as one that will be quickly resolved. However, we are yet to see major central bank intervention in the euro nor the implementation of the E720bn stabilisation fund. The ECB has only just begun to buy eurozone bonds and Greece has received its first payments from its E110bn rescue package. There is a very good chance the euro will fall further, but then stabilise. Europe will be in the doldrums for years to come but it will likely not disintegrate, one would suspect. Although such a possibility cannot be definitively ruled out.
In Australia, there is little chance the RSPT will ever “get through” as is and every chance a compromise will be reached before the election. Or maybe Rudd will lose the election. There is every chance the threats currently being made by big miners are extreme in their intended impact.
There is every chance Goldman Sachs which reach some kind of settlement with US regulators (being the more powerful of the two parties) and that the US financial regulation bill, again rejected by the US Senate last night, will also be watered down.
There is every chance China will now think twice about further tightening measures.
It is not a time to go barreling into the market, looking to be a bottom-picking hero. But it is a time to reflect that a weaker Aussie dollar is good for exports and that Aussie shares, particularly resource sector and bank shares, are now looking “cheap” on valuation rather than “dear” as they were at the peak, assuming earnings forecasts do not need to be materially slashed from here. Downgrading has already been occurring.
It is also time to reflect that fear itself has been the biggest driver of fear in the market this past month. Contrarians love such fear.
