Bloody markets

Since the beginning of August, global stockmarkets have fallen by 13.2%, and a temporary rebound between the 11th and the 15th proved short-lived. As of last Friday, global stockmarkets are back down to their lows for the month. Most markets have moved into the zone of a technical correction (a drop of more than 10%), whilst some are now in official bear market territory (-20%). Market moves that used to take months to play out are now occurring in the space of days or even hours.


The sharp falls of the last few weeks reflect the rapidly heightened concern amongst investors over the reluctance of politicians to recognise the depth of the problems confronting them, with the result that the crafting of solutions has been left to central bankers, who are stretching ever longer the limits of their official remit.


The ECB is getting deeper into the mire of supporting the sovereign bond market in Europe, whilst the Federal Reserve in the US has made a commitment to keeping real interest rates negative for the next two years.


Regrettably, however, both central banks are now getting to the point at which they can do little more. The recent experience of the US with QE2 bears this out: printing money has had little effect in helping to boost the economy, since if consumers and companies don't want to borrow, it doesn't matter how low lending rates go since it's not the price that matters any more... it's the perception of risk. The problem is not one of liquidity.


In Europe, the ECB can absorb sovereign debt issues without end, but lacking a collective and explicit guarantee from all Eurozone countries in support of future loans, eventually the ECB will run out of capacity and widespread sovereign defaults become inevitable. It may be that, at that point, the rest of the Eurozone will rally around with the necessary guarantees. It will take a crisis to get there.


In any event, a global recession now seems inevitable, given the limited policy tools available to governments and central bankers to prevent one (try getting another stimulus package past the Tea Party in the US, for instance). It therefore needs to be said that expectations that the recent "soft patch" in economic data would turn round, prompting a continuation of the gradual recovery now look optimistic (you might want to preface "optimistic" with the word "hopelessly"). We have been as guilty of that as anyone else.


It goes against logic that - post a Eurozone debt crisis and the recent US fiasco over the lifting of the debt ceiling - if developed world government spending accounts for more than 1/3rd of GDP and that is financed by deficit spending which needs to be cut, government spending across the board is going to be cut, whilst taxes are raised simultaneously. With private sector demand still anemic and fearful, the slack won't be offset by increased demand from elsewhere, so - by definition - global GDP will decline. China and the emerging world are not in such bad shape in debt terms, but they are exposed to slowing global trade, so they too, will be affected.


We then get on to the point of trying to determine how big and how long will the recession last, and how much of this has been discounted by stockmarkets? In addition, with interest rates so low, do these provide a degree of support for risk assets that have not been a feature of previous recessions?

On the first - not being an economist - I'd admit that this is complete guesswork (maybe economists should admit this too...). However, logic suggests that any deficit and debt reduction programme will talks years no months, and that this will drag on economic growth for a while. It may well be the case, however, that greater clarity will eventually encourage the private sector to begin deploying its cash thereby limiting the depth of the recession itself. In this, prevailing low interest rates will eventually help, as will a marked falling off in inflation.

What's less easy is to determine how much of this recessionary risk is now discounted by stockmarkets.

John Mauldin, in his online weekly "Thoughts From The Frontline", suggests that on average, stocks drop more than 40% in a recession. He also notes that with the recent economic data from the US looking pretty grim, markets have further to fall as do bond yields. If he's right than the corrections we have seen thus far in stockmarkets are a foretaste of further declines, and that any bounces we see on the basis of short-term policy fixes (like the one that may well accompany Bernanke's policy speech this week from Jackson Hole), should probably be sold into. As Mauldin says, we are now at the point where "not much can be done, other than than just get through it as best we can. [Since] this will offer some very interesting opportunities, I am not one for digging a hole and crawling in it".

To paraphrase Oliver Cromwell, you may keep your faith in God, Ben Bernanke, the ECB, Angela Merkel etc., but keep your powder dry. The markets we're looking at closely would be those that will benefit from reduced inflation and increased consumer demand at home: Asia, India, China etc (the latter two having underperformed for some while), luxury goods themes, commodities and high yield fixed income on further weakness.



Steve