Global equities are in a bear market. But that does not mean that equity prices will just go down in a straight line. There have already been rallies and there will be more before equity markets reach a bottom. Indeed, I expect a large rally is now in the offing.
For instance, on March 17, the US Federal Reserve announced that it had arranged to bail out collapsing investment house Bear Stearns, with JPMorgan buying the company for $2 (ultimately $10) a share. That was the signal for a global equity market rally.
The Fed had acted to avert a systemic financial crisis and, as Lehman’s chief executive, Dick Fuld, put it, "the worst is behind us". The consensus was that the credit crunch would now dissipate and that the economy would avoid a recession.
Equity markets continued to rise until mid-May. After that, though, they tumbled back, so that the MSCI world index is now below that March low. Indeed, global equities are now down 12% year to date and around 20% from the high of October 2007. The global index is now at its lowest level since October 2006. The equity bear market is confirmed.
Reality finally brought wishful thinking to an end through a combination of ever-mounting losses for banks and financial institutions, record high oil and food price inflation, collapsing property prices, and dismal corporate earnings and economic data.
To date, banks and financial houses have written off more than $425 billion of their assets. The cost of capital, as expressed in corporate bond yields and mortgage rates, has moved higher. Corporate earnings are now in negative territory in the US and Europe. Above all, real GDP figures are heading south everywhere, while inflation rates are heading north. That is a deadly combination.
From here, the credit cycle is moving from big percentage losses incurred in sub-prime mortgage debt to the more typical small percentage losses in the general mortgage, consumer and corporate sectors that are incurred in an economic recession. Liquidity contraction will ricochet through more pools of debt, causing leverage to contract for the real economy. That will hit financial market prices further.
But this bear market will be characterized by more rallies. For example, with financial markets so geared to the oil price, any significant drop in energy prices could promote a 7% to 10% equity rally. As I write, a $10 a barrel fall in the oil price has induced the sharpest one-day rally in financial sector equities.
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Time for a rally? |
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MSCI world index, year to date |
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Source: Datastream |
But the underlying trend will remain down. We are barely halfway through the likely total losses that the financial sector will suffer from the credit crunch and the ensuing economic recession.
In the US, losses from sub-prime mortgages have been joined by those from the prime mortgage market (as Fannie Mae and Freddie Mac can testify). Losses are coming from the commercial mortgage market too.
Rising charge-offs on consumer credit cards indicate that property losses will be compounded with losses in the broad corporate and consumer sectors – in Europe and Asia as well as in the US.
The global economy is heading into a recession, as the economic data are beginning to reveal. This will be expressed in falling profit margins and negative earnings growth. That’s bad news for equities.
The other big worry is inflation. This monster has risen from the depths. And it was emerging markets that led the inflation charge as China, India, Indonesia and many others had record-high price rises. For the first time in more than a decade, emerging economies are contributing to global inflation rather than squeezing it. This inflation is no longer being imported through global food and energy prices but is feeding into domestic wage inflation and raising inflation expectations.
Inflation is ultimately about monetary policy. Lax monetary policy creates pools of speculative capital that inflate asset prices and create excessive demand. Central banks are caught between a rock and hard place: the need to tighten to control inflation and the need to ease to help avoid recession.
As the US rolls into economic recession, the Fed under Ben Bernanke is more likely to maintain negative real interest rates, while the European Central Bank stays positive. So I expect the euro and the Swiss franc to appreciate more against the greenback.