BackSafe havens for bubbles
Quantitative easing and low interest rates do not generate new sources of growth, but simply borrow growth from the future
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Discussions on the possibility of a US Federal Reserve rate hike in December and its implications have been dominated by the recent bomb attacks and deaths in Paris. It has larger implications for financial markets in the long term. Financial markets are their myopic self, as usual. Stock markets around the world have rallied in the week after the Paris bomb attacks. It used to be said that what was bad news for Main Street was bad news for Wall Street. Now, what is bad news for the world at large seems to be good news for Wall Street. That is not a good sign. That shows that there is great divergence between fundamentals—economic and political—and financial assets. Financial assets seem to be exclusively focused on low interest rates and liquidity. Every piece of geo-economic and geopolitical bad news is interpreted only through the prism of low interest rates and liquidity. That is not a good thing.
The Paris attacks increase the political risk for Angela Merkel in Germany. Her “open arms" policy for refugees coming from Syria has already attracted opposition and resistance from her party members, including that of Wolfgang Schäuble, her deputy and the federal minister for finance. The claims that one of the Paris attackers was a Syrian migrant will harden positions within Germany. If the political pressure on the Chancellor rises on account of the Paris attacks, then it will be a big setback for the Europe project.
In Portugal, recent political headlines are not good. Portugal is not Greece. It is a bigger country and more significant. If the new government takes office soon, it will be ready to take the anti-austerity line. Greece is not solved yet. It is simmering. Hence, in other words, it is baffling that European stocks have surged in recent weeks and more so after the Paris attacks, unmindful of these developments and the implications of the attack for Merkel’s tenure in office in Germany. These developments will increase the pressure on the European Central Bank to undertake more quantitative easing (QE) in December. However, QE and low interest rates do not generate new sources of growth, but simply borrow growth from the future, along with all the costs that come with it—misallocation of credit, asset price bubbles and inequality, to name only a few.
In the US, as the stock market keeps hovering near all-time highs, the underlying market fundamentals are deteriorating and are not confirming the headline index levels. Very few stocks are making new highs. In other words, the market breadth is poor. More importantly, earnings growth has been trending down for the past four quarters. S&P 500 companies’ top-line growth has been negative for three consecutive quarters, too.
Moody’s Weekly Market Outlook (12 November) puts it bluntly: “The final quarter of 2015 is shaping up to be the second straight quarter of substantially fewer high-yield rating upgrades relative to downgrades. A convincing negative trend may be emerging." The share of upgrades in the US high-yield credit rating revisions will be 24% in the final quarter of 2015. This is the second worst since Q1 2009. On the last two occasions, the upgrade ratio broke under 40% in 1998 and in 2007—they constituted important turning points in the credit cycle.
In Asia, China stocks have rebounded after the summer doldrums. The Shanghai A-share index is at 3,800 points. It is up more than 25% from the lows. China has kept the credit tap open. Economic growth has not improved. Momentum is missing. The industrial sector is on a long-term decline while, at best, there are question marks over the ability of the service sector to make up for the collapse of the industrial sector. At worst, its resilience is overstated. According to a CLSA report, “China trust companies are growing in importance with trust assets now equal to 17% of bank loans at end June 2015." In other words, in the world of Chinese banks, the shadows have lengthened and have not shrunk.
Even as shadow banks continue to grow in size, the health of the conventional banking system is deeply suspect. The extent of non-performing assets in the Chinese banking system is estimated widely. The estimate varies from 6% to more than 20%. CLSA puts it at 8.1%. While the stock market bubble has resumed, China apparently has a bond market bubble to contend with too. In a news story published early in October, Bloomberg mentioned that bond prices had climbed to a six-year high and issuance had surged to a record.
Meanwhile, China’s corporate fundamentals continued to deteriorate. A recent Bloomberg article noted: “About 16% of companies on the Shanghai stock exchange lost money in the past 12 months, double the proportion last year, and the number of firms with debt levels twice their equity has doubled to 347 since 2007. Profits at Chinese industrial companies sank 8.8% in August from a year earlier, the biggest decline since the government began releasing monthly data in 2011."
The year 2016 could turn out to be an unforgettably long one for investors.
V. Anantha Nageswaran is co-founder of Aavishkaar Venture Fund and Takshashila Institution.
Comments are welcome at baretalk@livemint.com. To read V. Anantha Nageswaran’s previous columns, go to www.livemint.com/baretalk-
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