Developed markets headed for prolonged bear phase, emerging markets’ currencies and equities may come out unscathed.
Six months is a long time for market cycles. Not so long ago (last December, to be precise), celebrity strategists at foreign brokerages were betting on the revival of growth in the US. This resulted in rotation of funds from “expensive” emerging markets (EM) like India at the start of the calendar year. By February, the same strategists were writing the obituary of quantitative easing round two, as key macro-economic data belied their assumption. As we now know it, the recovery was a jobless one.
With the second round of quantitative easing failing to revive corporate growth, the world’s largest economy is preparing for a prolonged bear phase. Along with QE2, some long-standing distortions in asset prices (caused by excess liquidity) will also end due to structural changes. CLSA’s celebrated strategist Russel Napier calls it the “great reset”. He says: “The structural change associated with this ‘great reset’ could reduce the S&P500 to below its March 2009 lows — and potentially to 400.”
The primary reason behind this reset is falling demand for US Treasuries. For long, central banks around the world have invested a substantial portion of their reserves in US T-bills. Until 2010, foreign central banks were buyers of at least 40 per cent of total treasury issuance, but in the first quarter of 2011, these central banks have purchased merely 16 per cent of the issuance, while the Federal Reserve bought almost 200 per cent of total issuance.
Demand for US Treasury bills has a direct impact on asset prices. Over the last 10 years, strong demand for US T-Bills drove yields down, which had an impact on the cost of credit. Thus, low-cost debt boosted corporate earnings and economic growth. With foreign central banks moving to other currencies and safe havens, the US’s fiscal deficit will have to now be funded by the private sector. This also marks an end to the era of cheap money.
What does all this mean for emerging markets like India? Clearly, developed economies are in for difficult times. In contrast, as monetary policy action peaks in India, the investment cycle will revive and equities become viable again. Policy options in the developed world are limited and much less effective, says Napier in his report. He adds that investors should sit out this ‘great reset’ in currencies like the Singapore dollar and “move into EM government debt soon after. As EM monetary policy begins to ease, it will be a good time to move to EM equities”.
