Corrections or Bear Markets in Asset Prices?
BASED ON THE number of e-mails I receive and the types of questions I get asked, I have a fair idea of how investors are positioned. It is my impression, therefore, that the recent sudden sell-off in asset markets came as a surprise to the majority of investors and caught them – at least temporarily – on the wrong foot.
The most frequently asked questions came from India, where the market sold off within a few days by 20% from its high (it has since recovered modestly), and from Middle Eastern investors who were stunned when their stock markets declined by about 50% from their peak in late 2005 (see Figure 1). The decline in the Middle Eastern markets is remarkable because it occurred in an environment of near-record oil prices and at a time when liquidity was still increasing.
The best explanation I have for the decline in those markets is that, whereas Middle Eastern liquidity is still plentiful, the rate of growth has been slowing down. As my friends at GaveKal Research pointed out, “Bull markets, to keep going, need an ever growing stream of liquidity; for copper to rise 10% from US$2,000/ton to US$2,200/ton takes a little amount of money while a rise from US$8,000/ton to US$8,800/ton usually takes a lot more. In that respect, bull markets are like drug addicts whose next fix/liquidity injection provides diminishing returns. To get the same effects, the fix/liquidity injections need to always get bigger… Or serious withdrawal follows.”
The diminishing rate of liquidity growth aside, there may have been other reasons why stock markets in the Middle East tanked. The best time for equities tends to be at the end of an economic contraction or at the beginning of an expansion, when there is plenty of excess capacity. It is at these times that there is maximum liquidity in the system and, in the absence of heavy capital spending, stocks soar.
But once an increasing quantity of money is channelled from the financial sector into real economic activity – in the case of the Middle East, into grandiose residential and commercial construction projects and Ferraris – stocks frequently begin to stall or to decline abruptly. I mention this fact because the consensus among investors is that the global economy is booming. It is certainly the case that the boom is unprecedented in the history of capitalism.
Consider this: for the first 150 years of capitalism until the Second World War there was a colonial system in place. Under the colonial system, the rich industrial countries of the West (partly misguided by mercantilist economic policies) had little incentive to boost economic development and progress in the colonies.
The colonies were used principally to source raw materials, which were then processed into manufactured goods in the industrialised countries before being again exported to the colonies at high prices. These economic policies of imperialism led, in some cases, to a process of de-industrialisation in colonies such as 19th-century India. So, for the first 150 years of capitalism, the world didn’t experience strong, synchronized growth.
Then, following the breakdown of the colonial system during and immediately following the Second World War, close to 50% of the world’s population fell under communist and socialist rule, or had in place policies of “self-reliance” and “hostility towards foreign investors”.
Under these socialist systems, economic policies designed to stimulate the consumption of “butter” were avoided – largely at the expense of building an arsenal of heavy “guns” and unproductive heavy industries.
Following the breakdown of the socialist/communist ideology, which began with China’s Open Door Policy in 1978, the former socialist countries began to grow rapidly but in terms of size remained insignificant in the context of the global economy. In the 1980s, the Latin American countries went through a serious inflationary recession/depression, while declining oil prices took their toll on Russia and the Middle East.
Then, in the 1990s, Latin America began to recover strongly just as the world’s second-largest economy – Japan – went into a non-growth phase that lasted until just recently. At the same time, the Asian crisis of 1997 and the Russian crisis of 1998 lowered demand from Asia and the former Soviet Union.
By contrast, look at the global economy today! US consumption is strong – in fact, so strong that it has led to an exploding trade and current account deficit. In turn, these growing deficits have greased the world with liquidity and boosted economic growth rates through capital spending and industrial production, particularly in the Asian region.
An Asian consumption boom has followed, driven largely by employment gains, huge productivity improvements in China, and declining prices for manufactured goods, which significantly enlarged their market potential. A consequence of this boom in the Asian economies – and, in particular, in the Chinese economy – has been a significant increase in the demand for commodities, which has lifted the economies of Latin America, Africa, the Middle East, and the former Soviet Union.
At the same time, Europe has experienced an export-led recovery, driven by the emerging world, and Japan, also partly driven by exports, has begun to grow once again.
I admit that the above historical perspective is simplistic, but my point is that, today, we can say that – at least from an economic perspective – “this time is different”. It is a fact that we are truly in the midst of an unprecedented global synchronized expansion. And not only that!
The expansion is reaching just about every corner of the world and almost every sector of its economy – admittedly, however, at different intensities. Still, as I have repeatedly pointed out in earlier reports, the current global economic boom is characterised by huge and growing imbalances. Steve Roach believes that these imbalances can be solved benignly, but I believe there will be some serious rebalancing consequences.
Are Financial Assets the First Victims of the Current Economic Boom?
It is important to understand that even when central banks expand liquidity at an ever-increasing pace (Weimar hyperinflation, Latin America in the 1980s, Zimbabwe now), liquidity does tighten temporarily from time to time, as price and wage increases outpace money supply increases. So, whereas the German stock price index rose in paper marks from 100 in 1913 to 26 trillion in 1923, there were 20% short-term corrections (lasting usually just two months) in 1920, 1921, and 1922, and a 25% correction in 1923 (in US dollars).
(However, the index fell from 100 to a low of 2.72 in 1922, before recovering to 26.80 in December 1923.) As GaveKal Research pointed out (see above), in order to sustain a bull market in asset prices, an everincreasing pool of liquidity is required and this is, in the short run, impossible for a central bank to achieve – even if its intentions are “to print money”. In the example of the Middle Eastern stock markets referred to above, the prime drivers of liquidity are obviously oil production and oil prices.
From Figure 4, we can see that between 2002 and 2005, oil production soared from 25 million barrels a day to around 31 million barrels. The increase in production was accompanied by strong price increases. (Crude oil prices rose from $19 a barrel to $70.) However, at the end of 2005, oil production began to decline moderately and oil prices no longer rose. So, whereas liquidity was still plentiful, the rate of increase declined and led to a relative tightening of monetary conditions, which I suppose explains the dismal performance of the Middle Eastern stock markets over the last six months.
Aside from the Middle East, it is apparent that liquidity conditions around the world, while still expansionary, are less expansionary than in the 1999-2005 time frame. (Remember that it is the rate of change that matters the most.) From Figure 7, courtesy of Ed Yardeni, we can see that while bond yields are still below nominal GDP growth, they are no longer declining relative to nominal GDP growth, as they did between 2001 and 2004. So, we could argue that while an absolute tightening has not yet taken place, a relative tightening has been in force for the last 12 to 18 months. This would also seem to be confirmed by two other monetary indicators.
While Foreign Official Dollar Reserves are still expanding at an annual rate of 15% (no absolute tightening here), they are no longer increasing at an accelerating rate such as was the case between 2002 and 2005 – hence, a relative tightening is under way.
Now, whenever central banks create excess liquidity, symptoms of inflation will show up somewhere. Sometimes wages and consumer prices will react the most to expansionary monetary policies (for example, the 1960s and 1970s), but in today’s world where, given the low wages in China and India, an almost unlimited labour arbitrage can take place, easy monetary policies drive asset prices such as homes, commodities, equities, art, and so on, higher, while wages and consumer prices rise only with a lengthy time lag (once commodity prices begin to be passed on in the prices of finished manufactured goods).
Therefore, it should come as no surprise that, when liquidity growth is slowing down, asset prices begin to cave in first. This is especially true of equities, since the stock market discounts economic events well ahead of time. In this respect, it is interesting to note that while home prices in the US have continued to rise nationwide, homebuilding shares peaked out in the summer of 2005.
Since I wrote extensively about the homebuilding industry last year, I shall refrain from making additional negative comments here, except to say that conditions have since deteriorated badly, with the number of total single-family homes available for sale (existing and new single-family homes) rising to a record high (see Figure 12, courtesy of David Rosenberg and Richard Bernstein). At the same time, the Home Buying Intentions Index is at its lowest level since 1991. I might add that when homebuilding shares peaked in the summer of 2005, analysts remained very positive on this sector.
But, as I have repeatedly pointed out, it usually pays to listen to the market. And in this respect, we should take rather seriously the sharp break in equity and commodity prices, as well as in some of the emerging market currencies, that we experienced in the second half of May. The break may prove to be only of very brief duration with new highs to follow, but the impulsive nature of the break suggests differently – at least for now.
Naturally, investors will immediately ask why stocks and commodities should sell off when we are in the midst of a global synchronised economic expansion, when corporate profits are still expanding. The point is that, precisely because we are in a global boom, liquidity is likely to become tighter for a while and that, as just outlined, in such an environment equities and other asset prices are vulnerable until liquidity conditions improve once again.
Another reason for the sell-off could be accelerating inflation, about which we have frequently commented in recent reports and which may have a very negative impact on discretionary spending and corporate profitability, and could even lead to a global recession with some time lag. I hope that our readers will have noticed that their cost of living is not currently rising by “core inflation” but by between 5% and 6% per annum. (The US Cleveland Fed Median CPI rose in April at an annual rate of close to 6%.) Other reasons for the sudden decline in equities could be the threat of a pandemic or geopolitical tensions, which could lead, if not to a military conflict, then possibly to a trade war or competitive devaluations. It is important for investors to understand that when markets begin to move sharply in the opposite direction of the prevailing trend – that is, from down to up or from up to down, as was the case just recently – the reason for the trend reversal is usually not known for quite some time.
But a well-established fact is that equity bull markets get under way amidst dismal economic and financial conditions, while bear markets begin when everything looks at its brightest, such as was recently the case (at least superficially). Moreover, the more speculation there was in a market, the more likely it is that the correction could be serious and take the proportions of a bear market (down 20-40% or more).
Near – and Longer-Term Considerations
I have to confess that I did hesitate for a long time before deciding to commit to paper the following observations, as they will undoubtedly cause some confusion, given the views I have expressed in earlier reports. However, there are times when, within a long-term view, short-term considerations become more significant. From a longer-term perspective, I still maintain that central banks – especially the US Federal Reserve – will have no other option than to print money and that, therefore, in the long run, asset prices will continue to increase – at least in nominal terms.
US MZM has soared as a percentage of GDP in recent years and, as in the case of Japan, has created a huge monetary overhang. And while monetary conditions have tightened relatively in both Japan and the US, because money supply is no longer expanding as a percentage of GDP, looking at credit growth there can be no question that monetary polices are still expansionary. I am grateful to Kurt Richebächer for having recently pointed out that, in the US, in the fourth quarter of 2005, non-financial credit expanded at a new annual record rate of US$2,445.7 billion.
According to Richebächer, this compares with US$1,710.5 billion in the second quarter of 2004, at the end of which the Fed started its rate hikes. Financial credit increased US$1,224.4 billion, as against US$932.7 billion in the second quarter of 2004. In aggregate, overall financial and non-financial credit growth accelerated over this period of rate hikes from US$2,643.2 billion in the second quarter of 2004 to US$3,670.1 billion in the fourth quarter of 2005. In percentage terms, borrowing and lending increased a staggering 38.9%.
According to Richebächer, “the fact to see is that all the rate hikes were undertaken in [the] complete absence of any monetary tightening. Plainly, the Fed has readily provided any bank reserves that the financial system has needed to maintain its credit expansion. It is a farce of monetary tightening. For all of 2005, total credit expanded by $3,340 trillion, to $40,230 trillion, up more than $500 billion from 2004’s record $2,818 trillion increase. For comparison, annual total credit growth averaged $1,237 trillion during the 1990s. Trying to capture the dynamics, we compare the credit expansion with the simultaneous increase in real and nominal GDP. Well, in real terms, it was up $378.9 billion in 2005, and in current dollars, 751.4 billion.”
So, in order to generate nominal GDP growth of US$751 billion, in 2005, total credit market debt had to increase by US$3,340 trillion – 4.4 times faster than GDP. Now, as is the case for the current account deficit, which hovers around 7% of GDP at present, the optimists will say that debt growth that is four times larger than GDP growth is sustainable. This may be the case for now, but the point is that, in the 1950s and 1960s, debt and GDP grew at about the same rate, with the result that in 1980, when Paul Volcker tightened meaningfully, total credit market debt was “only” about 130% of GDP.
Then, in the 1980s, debt grew at about two-and-a-half times GDP, in the 1990s at about three times GDP, and now at more than four times. In other words, as GaveKal Research pointed out, in order to sustain the asset bull markets and the economic expansion, debt growth will have to accelerate soon to initially five times GDP, later to six times, and if we extrapolate the trend that has prevailed since the 1960s, eventually to more than 20 times GDP.
Similarly, the current account deficit, which grew from 2% of GDP in 1998 to around 7% of GDP, would have to triple to around 20% of GDP in the next five to seven years in order to sustain the growth rates in foreign official dollar reserves (global liquidity) and economic growth around the world, if the recent trend is extrapolated. Also not forgotten is the US saving rate, which declined from an average of 9% in the 1970s to less than zero at present and turbo- charged the economy. If the stimulative economic impact of a declining saving rate is to be maintained, the saving rate will eventually have to be at around -10%.
Now, you don’t need to be an economist with a Harvard education to see that these trends are not sustainable in the long run. However, it is my belief that the Fed, and other central banks which are at least as agile at printing money as the Fed is, will try to postpone the hour of truth by a renewed massive liquidity injection when the next recession arrives. So, my concern remains the same: before the final debt crisis hits, we might see very high rates of inflation – most likely hyperinflation, with all asset and consumer prices soaring (amidst falling real incomes).
Until next time,
July 6, 2006