Andy Xie view on current economic conditions

Stimulus, Storytelling and Bouncing Bears

20 Jul 2009
Caijing.com.cn

There is a saying on the stock market: Sell in May, and go away. Fund managers tend to take summer holidays. Before leaving, they tend to shift portfolios into conservative positions. In statistics jargon, this means decreasing the portfolio beta. When all fund managers do this, it amounts to a significant reduction in risk appetite that can push the market down.

What's occurring now seems to affirm this saying. Stock markets around the world (except China's A-share market) have been trending down since mid-June. The S&P 500 Index bottomed in early March at 676, peaked at 946 in mid-June, and declined to 901 by July 13. Similarly, the Hang Seng Index bottomed at 11,345 in early March, peaked at 18,888 on June 1, and declined to 17,663 on July 13. Other stock markets have shown similar trends. Odds are that the declining trend will continue into August.

At the end of 2008, I predicted a big bear market bounce in spring 2009. The bounce would fizzle out in the fourth quarter 2009 as inflation concerns trigger expectations of an interest rate increase. I modified this view two months ago to add a correction in the middle of the bear market rally, i.e. the market would be M shaped in 2009.

The reason for the change was that economic data failed to improve as fast as the market hoped. Disappointment would cause a mid-year dip. The market was excited by improving production data in the second quarter. I thought this was mainly due to the inventory cycle, and that final demand data would disappoint. Economic data so far has affirmed my expectations. I think final demand will improve only marginally in the third quarter due to the delayed effect of the fiscal stimulus, which will improve market sentiment again. Expectations for an interest rate increase will weigh on the market in the fourth quarter and bring an end to the bear market bounce.

All asset prices seem to be correlated to risk appetite. The most important is the dollar's inverse correlation with stock market performance. The dollar index peaked in early March at 89 and has been fluctuating around 80 ever since. Even though the dollar has been on a downward trend since 2002, losing about one-third of its value, it has staged numerous bounces along the way. These bounces reflect risk appetite in financial markets. The dollar remains a safe haven asset. When risk appetite falls, the dollar tends to rise. Rising risk aversion drives such dollar bounces.

Oil prices also show a high correlation with the dollar. They doubled to US$ 70 a barrel from a March low but tumbled to US$ 60 after the dollar began to bounce back in early June. I think the relationship between oil prices and the dollar is mostly correlation and some causality. In theory, if the dollar declines by one-third and everything else remains the same, it justifies a roughly 50 percent increase in oil prices.

However, the correlation between oil prices and the dollar is far more sensitive. For example, an 11 percent decline in the dollar index in spring was accompanied by about a doubling of oil prices. A mere 3 percent bounce in the dollar since has been accompanied by a 14 percent decline in oil prices. Liquidity, driven by risk appetite, drives the dollar and oil prices in the short term.

Risk appetite is determined by push factor-interest rates and the pull factor-economic growth. When growth and interest rates are high, risk appetite is moderate. When the growth rate is low and interest rates high, risk appetite is low. When growth is strong and interest rates low, risk appetite is high. This scenario fits the 2003-'07 situation. When economic growth rates and interest rates are low, which is the current situation in the world, risk appetite fluctuates on the basis of economic data and policy action.

I think the global economy bottomed in the second quarter and will start to show some growth in the second half due to the delayed effect of the fiscal stimulus. When a financial system is broken, monetary stimulus doesn't work well. The market thinks the global economy bottomed in the second quarter also but expects more growth in the second half. I think developed economies may show 1 to 1.5 percent growth in the second half after a 6 percent decline over the previous four quarters. The market was hoping for much more. Anemic data released this summer has brought some reality back to the market. Expectations are being adjusted accordingly.

However, when the economic data improves significantly, probably in September, financial markets may turn enthusiastic about growth prospects again. At that time, inflation risk could still appear low. Markets could conjure up a scene of strong growth with low interest rates. The enthusiasm could bring a second wave to this bear market rally. Stock markets and commodities could regain or surpass their spring highs.

Neither low interest rates nor strong growth is realistic. Instead, the world is moving toward high interest rates and low growth rates, i.e. stagflation. Before the financial crisis, the global economy experienced a nearly 4 percent growth rate with half as much inflation. In the coming five years, I think the best scenario will be half the growth and twice the inflation. A lower growth rate would be due to a lack of rising leverage as a driver for demand, and a lower productivity growth rate, as the beneficial effects of globalization and IT have been absorbed. Higher inflation would be due to a surge in monetary supply for coping with the financial crisis. Excess money supply will become inflationary over time.

Financial markets are discussing exit strategies for central banks -- when and how to retrieve excess money supply before it ignites inflation. Central banks are reluctant to discuss this factor because they fear it would lead to expectations of rising interest rates, which would dampen economic recovery. This willingness to err on the "loose" side could boost long-term inflation rates.

Central banks still don't recognize the nature of the current downturn. It's not just cyclical. Schumpeterian creative destruction is a big part of the current downturn. As outdated businesses shut, laid-off workers spend time hunting for alternative employment. This is why the global economic recovery will be anemic and "jobless." When central banks see high unemployment rates, they see economic "slack." Stimulus could lead to more growth without causing inflation. If central banks want to fight Schumpeterian creative destruction with easy money, it could lead to high inflation and, in some cases, hyperinflation.

In the same context, financial markets are speculating about a second round of fiscal stimuli, especially by China and the United States. The purpose of the speculation is to alleviate growth fear among investors; more stimuli could always be applied to cope with low growth and, hence, investing may proceed without fear.

But a second stimulus round is quite unlikely, in my view. Huge budget deficits in Japan, Europe and the United States could make more stimuli backfire. Bond markets may decide that governments would all go bust and refuse to buy more fiscal bonds. The political backlash against high budget deficits may be just beginning, threatening support for another round of fiscal stimulus.

China has a small budget deficit and could afford a second stimulus round, if it wants. However, China's budget deficit is not as simple as it appears. A massive increase in Chinese bank lending, for example, has increased the budget deficit indirectly; loose lending could lead to bank losses for which the government is ultimately liable.

Higher debt levels at local government-owned companies should be included in the fiscal deficit. Still, it's fair to say the Chinese government's overall financial situation is strong enough to support another round of stimulus. But it still wouldn't bring back sustainable growth. The current lending boom has led to increased economic activities related to government- or SOE-led investments. There are few signs the growth is spreading sufficiently to private investment and consumption to create a self-sustaining growth cycle. The current round of stimulus has improved economic growth, but has also increased imbalance in the economy. A second round may add more to the negative side than the positive.

Even though the second round of stimulus is quite unlikely for the foreseeable future, financial markets will continue to speculate on its coming, especially when economic data is weak. Investors need stories like this to work up the courage to take the speculative plunge. When enough investors believe a story, markets are affected and believers are rewarded in the short term. This is why the supply and demand for story-making is infinite. When the story of a second stimulus round becomes too old for believing, there will be another story to catch investor imaginations.

Imagination is important when interest rates are low. A low interest rate by definition subsidizes borrowing. Ceteris paribus, low interest rates increase demand for speculation. Such speculation is rewarded if low interest rates simultaneously lead to economic recovery. Over the past two decades, this was almost always the case. Western consumers would respond to it and borrow more to spend. Hence, low interest rates could quickly lead to broad-based recovery. It paid to speculate when the interest rate was low.

The difference now is that consumer leverage in the West is too high. Even when the interest rate is zero, western consumers could not borrow to spend. Hence, the mechanism that transforms low interest rates into creating demand has broken. On the other hand, the transmission mechanism between low interest rates and financial speculation is alive; indeed, it's never been better. Herein lies the danger for speculators: A broad economic recovery won't come this time.

Most speculation on short-term market movement is futile. Most, if not all, market folklore is coincidence. Statistical evidence is too sketchy to make the correlation meaningful. The "sell in May and go away" folklore is no more meaningful than other stories, even though fund manager summer vacations make it sound more plausible. There are just enough exceptions to make the relationship unreliable.

Herd psychology and structural bias are the only significant factors for making predictions. The stock market has a bullish bias. Most participants invest other people's money. As any bonus in a rising market far exceeds punishment in a falling market, structural asymmetry gives the market a bullish bias. This factor is especially important when interest rates are low. Savers are given incentives to look for alternative investments for banking deposits when interest rates are low. Bullish fund managers are more likely to attract cash flow from savers. When the market is rising, savers could be caught up by the momentum and shift more to the stock market from bank deposits. The combination of this herd behavior and the structural bullish bias of fund managers lead to market spikes from time to time in a low interest rate environment.

Such market spikes can reverse on their own. Any spike will attract profit takers. Companies want to take advantage of such opportunities to raise funds. The outflow can bring down the market. The correction we are seeing now falls into this category. As interest rates remain low, the correction will attract new inflows that lead to new spikes. This is why I expect a second leg to this bear market rally in the autumn.

So far, most of the improving economic data is on the production side due to the inventory cycle. Final demand data has yet to improve significantly. They could show an improvement in the autumn, which lends more support to bullish sentiment. Hence, the second leg in this bear market rally could be quite vigorous as well.

The bear market rally ends when interest rates rise due to inflation expectations. As I have argued many times, the global economy is more inflation prone in the future than it was in the past. Low growth doesn't mean absence of inflation. The excess supply of money released during the financial crisis will trigger inflation first through higher commodity prices. The pressure for cost-of-living adjustments in labor spreads the cost push to wage increases. This spiral turns all the excess money into inflation. When this prospect becomes apparent, probably in early 2010, market expectations will shift to big interest rate hikes. I think the Fed will raise interest rates by 300 basis points over the next 18 months. Other central banks also will raise interest rates, but probably less than the Fed. High interest rates kill the power of imagination in the stock market and will end this bear market rally.