Equity markets across the world have staged a smart recovery in the last couple of months. The MSCI World index, which was down to 1,032 on 2 July, was at 1,145 on 10 August. Emerging markets have done much better as risk appetite has surged.
What could be the reason for this renewed bout of confidence? Let’s take the “fundamentals” first. One reason could be relief that the panic stemming from the fiscal crisis in some parts of Europe is now behind us. That’s seen from the returns from MSCI Greece in the last three months—14.9% in dollar terms. It’s yet another reminder, alas as usual with the benefit of hindsight, that the best time to buy is when there’s bloodbath on the Street.
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But the other indicators don’t offer much hope for the optimists. The JPMorgan Global Manufacturing and Services PMI (purchasing managers’ index) shows the momentum of the recovery has been slowing every month since April. Chris Williamson, chief economist at Markit, writes, “Compared with a peak of almost 4% in April, we estimate that the annual rate of worldwide GDP (gross domestic product) growth slowed to perhaps 2.5% in July.” In Europe, countries have started to tighten their fiscal belts, which is certain to hurt growth. In the US, most indicators have switched to yellow, if not red. These include falling home sales, subdued consumer spending and continued contraction in bank credit. The Economic Cycle Research Institute’s leading indicator has been predicting a slowdown for months. Even emerging markets haven’t been immune—Chinese growth has slowed appreciably, Brazilian PMI surveys show growth near 11-month lows and while India continues to do well, there are signs that capacity constraints have started to bite.
Why then have markets rallied in the face of slowing growth? One explanation is simply the amount of cash held by fund managers. The Bank of America-Merrill Lynch (BoA-ML) July survey of fund managers showed that cash balances with asset allocators were at 4.4% of assets, just a smidgeon below BoA-ML’s buy signal for equities, which flashes green when cash levels are at 4.5%. The Mark to Market column in this newspaper had then mentioned that there was plenty of fuel for a rally. Liquidity has thus been the prime factor behind the rally, seen in the Indian market by the resumption in foreign institutional investor (FII) inflows.
Funds tracker EPFR Global argues that the weakness in the developed economies has led to money flowing out to emerging markets. This is what it said recently: “Against a backdrop of disappointing US employment, manufacturing and housing markets data, investors steered their cash into emerging markets funds during early August as they sought protection from the dollar weakness they believe will follow. Flows into EPFR Global-tracked emerging markets equity funds hit a 38-week high during the seven days ending 4 August, with Global Emerging Markets Equity Funds having their best week since late 4Q08.” The US dollar index has fallen sharply since it peaked in early June.
But it’s not just emerging markets that have gained since June. The Sensex is up around 7.5% since then, but the French CAC 40 is up 7% and the German DAX almost 6%. What lay behind the dollar outflow was the hope that the US Federal Reserve would once again ride to the rescue of the markets, this time by inaugurating a new and improved edition of quantitative easing (QE).
So what did the Fed do on Tuesday? It finally acknowledged that the recovery in the US is showing signs of running out of steam. Its statement says clearly “the pace of economic recovery is likely to be more modest in the near term than had been anticipated”. It has also said that it will reinvest cash from maturing securities back into treasury bonds, signalling a shift from its earlier stance of pruning some of its vast holdings of mortgage-backed securities. This doesn’t really add up to the QE2 looked forward to by the markets, which explains the tepid reaction. Nevertheless, change of stance does keep the door open for a fresh bout of easing if economic conditions do not improve.
But further easing is unlikely to do anything to help a recovery in the US. Borrowing costs are already extremely low—the problem is that few people are borrowing. So far the attitude of the policymakers in the US has been to try and get back to conditions before the crisis, rather than take the hard decisions that will make the US economy structurally more competitive. And Japan is probably a perfect example of what happens when you go down that way.
At the moment, the markets seem to be more worried about the Fed’s pronouncements on slower growth and with disappointment that the Fed hasn’t done more. But with loose monetary conditions in the advanced economies and faltering growth, liquidity should be ample to support asset prices, while the prospect of further Fed easing will lead to rallies of the sort we’ve seen lately.
The bigger and unanswered question is what happens in the longer run, when the markets realize that the policy band-aids in the West are no longer working. The global economy, including its markets, is currently best described in Matthew Arnold’s words—“wandering between two worlds, one dead, the other powerless to be born”.
Manas Chakravarty looks at trends and issues in the financial markets. Send your comments at email@example.com