Stock markets are emotional discounting mechanisms, particularly during times of crisis. Nevertheless, underlying economic conditions move much more slowly than emotions. This is why investors need to keep a sense of perspective at times when stock prices are falling. If the U.S. avoids a double dip recession and China glides into an economic soft landing, then a floor should be created beneath the S&P 500. However, the worsening euro zone crisis will continue to pound risk assets. Essentially, we are dealing with trendless equity markets with tremendous price gyrations until decisive action is taken to diffuse the systemic risk in the euro zone financial system. Going into next year, several developments could occur that are likely to have a significant impact on financial markets.
First, a new global reflation cycle may well take place next year. The ECB was forced to cut rates and eventually may begin its own version of QE2 (quantitative easing). A pan euro zone recession will give the ECB legitimate reason to ease, but more time is needed before authorities there can be convinced of the need for buying (monetizing) government debt. This renewed reflation effort by the ECB could drive down the euro’s value, which in turn could prompt a reaction from the Fed. In other words, if a relatively stronger dollar begins to cause difficulty for American companies, the Fed may have to ease more to weaken the dollar and protect growth. Thus, QE3 by the Fed is an increasing possibility as a result of the euro zone crisis.
As for China, the People’s Bank of China may also begin easing policy early next year in the wake of a continued fall in inflation and softening growth. If they are lucky, the Chinese economy may bottom at 8% growth in the first half of 2012 and reaccelerate from there. If the numbers coming out of China are to be believed and barring a hard economic landing, this suggests that Asian stocks begin to outperform the global average early next year.
Second, additional monetary easing would do little to increase output because the entire West is stuck in a quasi-liquidity trap and interest rates are already at practically zero. Nevertheless, the usefulness of more monetary easing will be to remove systemic risk in the banking system and to avert deflation, both of which should be positive for stocks which have been plagued by excessive risk premiums. While investors could easily get emotional from multiple waves of massive price gyrations, they should be prepared for additional easing. In a world of steady, low nominal growth, equity multiples should hover around 13 times forward earnings; the S&P 500 is trading at about 11 today. Equity multiples are depressed by a heightened sense of risk and a lack of reflation in Europe. Hence, any reduction in risk perceptions should lead to a one-off rerating for share prices. However, if earnings collapse, then share prices will decline even as PEs expand.
Third, with short rates bound by zero, any monetary easing will amount to competitive currency devaluation. The country that eases the most will have the weakest currency and possibly some inflation. By the same token, those that resist reflation will end up with strong currencies and deflation.
- The Bank of Japan is the least aggressive in reflating its economy; as a result, the Yen is strengthening and price levels are declining
- The Bank of England has been the most aggressive in easing, which is consistent with a weak sterling and some inflation in the U.K. economy
In the end, economic pain and uneven growth distribution will equalize reflationary efforts across countries in the West, which means no currency can sustain a permanent devaluation or revaluation. This implies that the developed world will collectively devalue against the developing world where yields and growth are significantly higher. It also implies that the West will collectively depreciate against hard assets, especially gold.
In December, the equity, fixed income and commodity markets will focus on positive holiday retail numbers, any economic stimulus legislation that actually gets passed, and Angela Merkel’s and Nicolas Sarkozy’s proposed solutions to the European debt crisis.
Michael Ashley Schulman, CFA
Hollencrest Capital Management