The year 2012 has gotten off to a great start, with risk back on with a vengeance. Global equity markets are up across the board, and suddenly everything once again looks right with the world. In the US, the S&P 500 is off to its best start since 1987, and is being led by deep cyclicals (materials, home-builders, semiconductors) and financials. The worst-performing stocks and sectors of 2011 are clearly leading the way (in the US, the 50 worst-performing stocks of 2011 are up 10 per cent in the year to date, while the 50 best-performing stocks of 2011 are only up 2 per cent). Bonds in the US are off to their weakest start since 2003, with 10-year yields back above 2 per cent. The S&P 500 is now up 20 per cent from its early October lows, and is just about 3 per cent below its April 2011 post-crisis high. This pattern is repeated across markets, with large emerging markets leading the way.
Why has this rally taken shape? How much further can it go? Is India, one of the best performers this year, truly out of the woods?
The sources of this rally are ample liquidity, better short-term economic data and some of the more dire EU scenarios no longer being on the table.
The move by European Central Bank President Mario Draghi last month to provide huge amounts ($635 billion) of low-cost three-year funding to the EU banking system will clearly help banks de-leverage, and also provide indirect support to the EU sovereign debt markets. Investors have clearly taken time to understand how significant this move was. There is another round of such provisioning in February, and it could turn out to be even larger than last month’s. The ECB has managed to convince the markets that another Lehman-like tail-risk event is now highly unlikely. The fact is that, over the last six months, the ECB has grown its balance sheet by over 40 per cent, to the point where today, at euro 2.68 trillion, it is larger than the Federal Reserve’s.
We have a situation today where both the ECB and the Fed have balance sheets in excess of $3 trillion, bloated because of asset purchases, and where interest rates globally are effectively at zero. As another boost to sentiment, there is also a growing body of opinion that the Fed is laying the ground for a third round of quantitative easing, which may involve the purchase of another $500 billion to $1 trillion of securities, further turbo-charging global liquidity.
In terms of short-term economic data, the US economy continues to hold up. The latest jobless claims numbers show improvement, housing sales and starts are recovering and the weekly ECRI leading economic index is at its best level in five months. The latest manufacturing data out of China also seems to favour a soft landing scenario.
The latest European sovereign bond auctions are proceeding far more smoothly than one would have imagined a month back, with even Spain and Italy having no difficulty in placing their paper.
With this tide of liquidity overwhelming everything else, markets are seemingly once again getting complacent. The Vix index is once again down to 18, and most measures of market sentiment are back to where they were last May (just when the S&P 500 was peaking), while short interest has reduced to one-year lows. More worryingly, credit market indicators have lagged the improvement in equities.
This market seems to be still driven more by short covering and the lack of positioning, and could have more to go still, as the process of cash on the sidelines getting deployed is still underway.
As for things to worry about, the fundamental fact remains that liquidity just by itself cannot correct a basic solvency issue. To correct solvency, you need fundamental changes in competitiveness, entitlements and a reset of debt levels. These improvements require pain, time, political leadership and a willingness to challenge vested interests. Can the West take the pain needed to get itself out of this mess? Does it have the leadership?
Beyond this fundamental fact of solvency versus liquidity, one has to worry also about Portugal. Without much ado, bond yields and credit-default swap spreads have been rising here, and it seems to be following the Greek template. Also, while markets are euphoric about the ECB provisioning, what are the long-term implications of the Euro area banks being almost totally reliant on the ECB for funding? How will this ever be unwound? Even if their liquidity issues are resolved, how do these banks recapitalise? Who will give them equity, with the sovereign bust and public markets unwilling?
Even on economic growth, market complacency is surprising. Both the IMF and World Bank have just downgraded their global economic outlooks, and if you look at the Baltic Dry Index (which tracks the cost of moving bulk commodities, and is a good indicator of global growth), it is down 50 per cent in the past month.
The markets have also looked through the ratings downgrade of France, as well as the ongoing Greek debt restructuring saga. If Greece were to go into a disorderly default, the chances of which are rising by the day, the consequences for global markets can be catastrophic.
All-in-all, this still looks like a rally more to rent than to own. It may go on, probably till most investors get sucked in, but will eventually fade.
As for India, we are once again proving to be a very high beta play on global liquidity and risk appetite. India is up about 19 per cent in dollars, all in the span of three weeks. I hope this is not taken by our policy makers to be a sign that all is fine, everything is back to normal, everyone loves India again. Far from it. Because of the surge in risk appetite, we have been given some more time to get our house in order. We must take advantage of this respite and get moving on policy matters and try to improve domestic business confidence. We need to see a revival of domestic private-sector investment, and this is more linked to policy and regulatory reform than interest rates. Measures to stabilise the fiscal situation and improve efficacy of subsidies are still critical. The 2012 budget will be watched very keenly by investors everywhere as it is seen as the last budget in which the UPA can do anything before electoral compulsions take centre stage.
If we get our act together in India, our markets can continue doing well, even if global markets fade. If we think rising markets give us the licence to do nothing meaningful on the policy and fiscal front, then I am afraid our markets will come down again, irrespective of what happens globally.
The author is fund manager and CEO of Amansa Capital.
akashprakash@amansacapital.com
