Wednesday, March 17, 2010

Not So Steady As She Goes

A man walks past a video display showing financial information in  Tokyo, courtesy of artemuestra, Flickr.
Creative Commons Creative Commons

Tokyo stock index,

The US stock markets have recently notched over a dozen consecutive days of upward movement. There is, however, no cause for complacency,

By Robert M Cutler

In the 2007-2008 financial crisis period, volatility in equity markets worldwide spiked, driven by the US implosion. Since then, tolerance for risk has increased as the appearance of the end of the recession has taken hold.

This began with the Chinese markets, which, during much of last year, were the magnet for ‘hot money’ seeking risk and high reward. In response to Beijing’s fiscal policies, the country’s economy recovered from the US contagion and drove optimism on the international exchanges generally.

But then came the risk of overheating. In early January, however, the People’s Bank of China (PBoC), in concert with the country’s other financial regulatory agencies, implemented a series of rules in order to restrain bank lending in the country, because they were afraid that domestic ‘hot money’ would overheat the economy.

Two weeks later, the PBoC’s monetary policy bureau and other agencies took the extraordinary step of ordering a large number of major state banks temporarily to cease all lending. The Shanghai stock exchange indexes have since faltered. The ‘hot money’ began to look for other places, such as Japan and South Korea, and volatility in the Asian markets increased.

Nevertheless, as Robert Prechter, founder and president of the independent financial forecasting firm Elliott Wave International, explained to ISN Security watch, “volatility [also] tends to increase [even more] when markets fall,” because “fear is a more intense emotion than hope, and this qualitative difference shows up in volatility variance.”

US recovery skating on thin ice

A big problem with the present US market is its low volume, which betrays a lack of conviction in the direction of the move. Also, the investment firm Comstock Partners notes, for example, that the benchmark Standard and Poor’s 500 index rose 62 percent in the six-and-a-half months following March 2009, but only 4 percent since then.

Bloomberg News reports that shares in the S&P 500 now trade at the average historical level of 15 times estimated earnings. However, as the Wall Street Journal observes, different valuation methods for calculating this ratio yield results ranging from 14.5 to 20. Judging whether US stocks are correctly overvalued or not depends partly on the choice of method.

Much of the debate over the near-term future of the US economy has been couched in terms of alternative scenarios known as the ‘V-shaped’ recovery (where economic growth turns positive again without an intervening period of stagnation), the ‘U-shaped’ recovery (where there is such a period of stagnation), and the ‘W-shaped’ recovery (also known as the ‘double-dip,’ where there is another decline following the current partial recovery.

The US market seems still to be pricing in a ‘V’ expectation, but the general economy’s thin ice would not appear to justify this. Three examples will suffice: Forty percent of the unemployed have been unemployed for over six months (a record level); nearly 30 percent of US manufacturing capacity is idle; and over 5 million mortgagees are beyond on their payments. But the markets seem to act as if these problems have disappeared.

Still, just two months ago, the canonical volatility index for US markets (VIX, from the Chicago Board Options Exchange) spiked 32 percent in three days in response to a series of concatenated events that fuelled economic uncertainty.

As much as it may appear that fear breeds fear, Prechter contends that “volatility in stock markets is not causing such crises as concern over sovereign Greek debt or the fall in US residential housing prices.” On other hand, “as bear markets spread across asset classes around the globe, volatility increases concurrently.

An explosive synergy

And yet there may be worse on the horizon.

In January, US President Barack Obama proposed taking $30 billion of the money repaid by big banks under the Troubled Asset Relief Program (TARP) assistance plan and providing it to smaller community banks, which would then be expected to lend it to small businesses in order to preserve and create jobs. But there is a problem here.

Following on the first wave of home mortgage failures there is a second wave approaching, affecting regions not previously touched by the crisis - and this is in addition to new problems with commercial real estate. The question then is whether these banks will lend the money that they may get from Washington, or hoard it in order to buffer their balance sheets against possible defaults.

If US banks do not lend and if jobs are not created, US consumers will be unable to drive demand for Asian goods as they have historically done in the recent past. Chinese policy has attempted to take up this slack by creating domestic demand, but there will come a time when this is no longer possible because the domestic result will be counterproductive.

The Chinese authorities recently proclaimed their projection that the country’s growth rate would once again rise to the 8 percent level this year, which is generally estimated to be the figure necessary to create enough new jobs to prevent unemployment (and the consequent threat of social unrest) from increasing.

And there are even signs that Beijing has taken President Obama’s conciliatory manner as a sign of weakness, in the tradition of mutual miscalculations between the two sides in the past. China’s monetary and fiscal policy makers will not respond to US overtures to improve the US economy but rather to fears of social unrest in their own country. The resulting disconnect between the two sides would not bode well for onlookers around the world.

Robert M Cutler is a senior research fellow at the Institute of European, Russian and Eurasian Studies at Carleton University in Canada.

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