On many occasions in the course of the global financial crisis in 2007-08, Wile E. Coyote was invoked by many commentators. The fact that Bare Talk is invoking this analogy again so quickly to describe the global stock markets says a lot about investor attitudes and mindsets these days. In fact, it all feels rather repetitive. Investors are back to ignoring risks, as they were doing in 2006 and 2007. Again, it is global, as then.
In early March, stock markets appeared oversold. The Standard and Poor’s (S&P’s) 500 stock index was around 665 on 9 March. It has rallied nearly 40% since then. Notwithstanding two mysterious back-to-back last-hour rallies last week, the bulk of the gains was made in March-April.
Initially, it was about things getting worse but more slowly than before. Then, there was the boldness to suggest that, actually, economic conditions might be turning positive. That provided the second or third leg for the stock market. Now, news flow has turned negative again. Yet, stock investors are ignoring it. So, stock prices are beginning to levitate without fundamental support. That is the Coyote moment.
Home foreclosures are still rising. Mortgage loan delinquencies are at a record high. JPMorgan talks of challenging times in the credit card market. Inventory of unsold homes has risen. The 30-year fixed mortgage interest rate went up by 25 basis points in just one week, last week. Retail spending by consumers in April disappointed, and orders for durable goods are languishing at record lows. Although the number for April was better than expected, data for previous months has been revised down significantly. Nearly seven million people receive unemployment insurance benefits, and the number keeps rising.
The Federal Deposit Insurance Corporation’s (FDIC) first quarter report on the state of the US banking industry shows that the quantum of bad and doubtful levels is rising and is higher than ever before—FDIC has data going back to 1984. Separately, the index of activity recorded by purchasing managers in the Chicago Federal Reserve region took a big dive in May. The recent spell of improvements has come to a stop.
In the meantime, inflation expectations in the US are proving stickier. Consumers, despite all their debt problems and diminished spending power, are now anticipating higher inflation than they did six months ago. They know that the retail price of petrol is up at least 70% from its low. The favourable base effect from falling oil prices is about to disappear. US Federal Reserve chairman Ben Bernanke took note of the elevated inflation expectations in his testimony to the US Congress on 5 May.
In the April meeting of the US Federal Open Market Committee (FOMC), some members warned against complacency on inflation. They took note of the fact that resource slack (capacity underutilization in industry and the unemployment rate indicate unused resources) might not be as high as is thought, especially if the maximum growth attainable by the economy has come down.
Tellingly, in their forecast revisions, regional Federal Reserve banks upped their estimates for unemployment and inflation while bringing down growth forecasts for 2009 and 2010. So much for “green shoots”, a phrase not used even once in the April meeting of FOMC, if the minutes of the meeting are any indication. In other words, stagflation (economic stagnation+high inflation) risks are rising, according to the Federal Reserve itself.
Despite a surprisingly large drop in the 10-year US treasury yield in the last two days of last week, the yield is well above the low of around 2% in February. Many point to the Fed’s purchase of US treasury securities as one reason why treasury yields cannot rise. That is unpersuasive. Quantitative easing—or direct injection of cash into the economy by the central bank through purchase of (government or private) debt securities—is similar to central bank foreign exchange interventions.
Not all foreign exchange interventions succeed, and certainly not all the time. Central bank intervention in the foreign exchange market has worked when it was reinforcing the trend rather than trying to buck it. Similarly, if rising US government borrowing and eroding anti-inflation credibility of the US government dictate that bond yields have seen their lows already, Federal Reserve quantitative easing would end up pushing yields higher rather than lower.
Hence, if there is a V-shaped recovery in economic growth in the US (a view that Bare Talk does not subscribe to), there will be an inevitable V-shaped rise in inflation and in US bond yields, bringing any balance sheet improvement for US households back to earth with a big thud.
So, the Coyote moment has arrived. We don’t know when the market would realize that it is floating on thin air. Smart investors would not wait for that day. This also applies to investors in the so-called decoupled emerging markets. We shall deal with this next week.
V. Anantha Nageswaran is chief investment officer for an international wealth manager. These are his personal views. Your comments are welcome at firstname.lastname@example.org