The news about the global economy continues to be grim, but there’s some fresh air blowing in the markets. February has started off with market rallies on the hope that the fiscal push being readied by governments will pull the economy out of the hole it has fallen into.
Quite a few indicators are now pointing towards optimism. The US TED spread, or the difference between the three-month dollar Libor (London interbank offered rate) and three-month treasury bills, a measure of risk aversion, is now down to levels last seen in the middle of August. US treasury bill prices have been falling and yields rising, an indication that some of the money that had rushed to this safe haven is venturing out again. Junk bond yields have declined. Fund tracker EPFR Global says investors are pulling out of US money-market funds and heading to emerging-market equities, high-yield bonds and US growth funds.
More importantly, there have also been some recent positive signs among the “fundamental” indicators. Chief among them are the purchasing managers’ surveys, which show that although the global economy continues to contract, the pace of contraction has slowed. In China, government bond prices have declined for the third week running on hopes of an economic recovery after the country’s banks lent record amounts in January. The UBS Bloomberg Constant Maturity Commodity Index has been bumping along at the 850 level for the last month, off the depths it plumbed last December. There has also been a surge in the Baltic Dry Index (BDI), which has more than doubled from its December lows. Shipments of iron ore to China have resumed and prices have moved up. Chinese steel prices are up smartly from their lows. Back home, too, there is some encouraging news. Automobile sales, for instance, seem to have picked up. Cement dispatches are robust. Tata Steel recently reported its steel sales were up 26% year-on-year in January.
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Are these the first green shoots of recovery? Perhaps one way to explain the rebound is inventory restocking. As the economic slowdown gathered steam and demand fell, companies responded by running down inventories. The ABN Amro Manufacturing PMI (Purchasing Managers’ Index) for India, for instance, has a finished goods sub-index that fell steadily every month from 50.1 in September 2008 (a reading above 50 denotes expansion while one below 50 denotes contraction) to a low of 45.6 in December. That illustrates the slashing of inventory by businesses.
The inventory correction was made worse because of the credit crunch during the last quarter, which made it difficult for firms to finance operations. BHP Billiton recently said a massive build-up of iron ore stockpiles in China that prompted suppliers to defer millions of tonnes in shipments last year is ending, pushing spot prices higher.
Daniel McCormack, Asia equity strategist for Macquarie Securities, points out that production in Asia fell harder than consumption due to destocking. In a presentation made in Mumbai on 22 January, he said that while consumption in Asia had fallen 2.5% from the peak, production was down 4%, because of the inventory swings. “Inventory corrections always hit Asia hard and this is the largest inventory correction in living memory. This is partly because inventories were high and partly because firms cannot obtain the finance to buy,” he says.
So when will the destocking end and production rebound? McCormack says that should happen over the next three months, when some of these four things occur: Inventory levels become critically low; demand stabilizes; financing problems are resolved and commodity prices hit the bottoms reached in 1998 and 2002.
Writing in the Chinese economic magazine Caijing, former Morgan Stanley economist Andy Xie points out the similarities with 1998. Writes Xie: “Before the middle of 2009, destocking will likely have finished and restocking may kick in. That extra source of demand may give the global economy a significant kick. I wouldn’t be surprised if the BDI doubled or even tripled from the current level by then. East Asian economies experienced a similar force in the fourth quarter of 1998. Destocking was actually the most important source of contraction in early 1998. Like now, the reversal of price expectation and the rising capital cost incentivized manufacturers and distributors to run down their inventories as low as possible.”
Recent reports indicate that some restocking has already begun. Perhaps it’s the result of the ebbing of the financial difficulties that plagued firms in the December quarter. Note also that the full impact of the huge Chinese fiscal stimulus should also be felt in the next six months or so. As the market discounts these factors, equities are likely to rise.
That doesn’t mean, though, that it’s the end of the bear market. As a report by Standard Chartered points out, US sales have fallen faster than firms could cut output, resulting in a piling up of inventories. That’s the reason why the contraction in US gross domestic product (GDP) was a lower-than-expected 3.8% in the last quarter of 2008. The inventories are expected to be slashed in the current quarter, leading to a gut-wrenching 6% decline in first quarter US GDP. Needless to add, the impact of this will be reflected in Asian exports.
Xie also agrees that inventory restocking is obviously a temporary force. For the bear market to end, we’ll need more evidence the global economy is bottoming out.
Manas Chakravarty looks at trends and issues in the financial markets. Your comments are welcome at firstname.lastname@example.org