It's probably too early to call a bottom in global equity markets, but the thought is tempting after looking at the past week and discovering that we're still standing. Survival is always a confidence builder.
Still, this is no time to be a roaring bull, although some degree of optimism may be just the ticket. We're oriented toward a contrary approach to portfolio strategy generally speaking, but that's tempered by a healthy respect for risk and reward. And there's still a lot of risk lurking in the global economy, and a fair amount of that continues bubbling within the U.S. In short, we still think the remainder of 2008 will be a challenging year on a number of fronts. That leads us to favor oppotunistic nibbling in asset classes where the margin of safety is relatively higher than, say, a year ago.
That said, it's tempting to think that the point of maximum stress for the capital markets has come and gone this week. The Bear Stearns (BSC) implosion a few days back promises to be the poster child for the current correction, much as Long Term Capital Management and Enron were for past purges.
Of course, there's no way to say for sure if even greater hazards await. A number of economists we chat with regularly say that there's still a risk that the current troubles in the U.S. could linger longer and cut deeper than the crowd expects. We're told that the hangover from a generational accumulation of debt on the consumer level is one potential trouble spot for the years ahead.
More immediately, the liquidity crunch in the financial sector is another issue, although some cautious pundits are now saying that the worst on this front may have passed. Meanwhile, the sharp drop in commodities this week, much of it coming on Thursday, is encouraging some to see the glass as half full rather than half empty.
One example of the emergence in the past few days of cautious optimism - if we can call it that - in some corners is evident in a Bloomberg News story on Friday titled "Commodities Drop, Rally in Dollar, Stocks Vindicate Bernanke. The following is a quote from Ron Goodis, the retail trading director at Equidex Brokerage Group:
Bernanke took care of the commodity bubble. Commodities are coming back to earth. The stock market looks okay, and Bernanke is starting to look a little better.
Here is another quote from the Bloomberg story. This one comes from Keith Hembre, chief economist at FAF Advisors:
Clearly they've gotten some stability. You have to stand back and say, for the time being, it looks to be a pretty successful combination of moves that have worked.
We're not willing to go that far, at least not yet. Nonetheless, no one should discount the possibility that equities could stage a rally in the coming days and weeks. And even if the bear continues to roar later this year, there's reason to think that maybe, perhaps, the second half of 2008 will deliver relative stability.
Barclays Capital pitched the idea of recovery, albeit cautiously at a press briefing on Thursday in New York. This writer sat in on the presentation and heard the argument that the Fed will do whatever it takes to insure that the current liquidity ills among banks don't get any worse. So said Larry Kantor, head of research for Barclays Capital in the U.S. Although he recognized on Thursday that "we're in the middle of a financial crisis," he suggested that there's reason to think that the crisis won't deteriorate further and that in the near future the pressures may start to ease considerably.
Kantor reminded that the value of assets in the eye of the current storm reflect both the underlying intrinsic worth and liquidity, and it's been the absence of the latter that's weighing on the financial sector. If the Fed can remove this weight, it'll go a long way in lowering prospective risk, Kantor explained. What's more, he said the odds of the Fed succeeding look pretty good now that the Bear Stearns debacle has passed without (as yet) a secondary effect. Certainly the outlook looks better now compared to Monday morning, when the Bear Stearns news hit. And so Kantor said that the odds of another Bear Stearns collapse are much lower now by his reckoning.
Meanwhile, Kantor notes that the stimulus checks that will soon be sent out by the U.S. Treasury to taxpayers will help juice the economy, if only slightly, later this year. He adds that corporate balance sheets are in good shape and employment rolls are far from being bloated so the odds of big layoffs may be lower than usual relative to past cyclical downturns.
Maybe, maybe not. Only time can say for sure. Meantime, the case for limited buying on any future dips in equities looks reasonably compelling. With that in mind, here's a broad look at how the global equity markets have fared so far this year. Every major region is deep in red ink, although the pain is more acute in some areas.
The emerging markets in Asia have been especially pummeled, as our chart below shows. As of last night's close, emerging Asia is down 20% in dollar terms so far in 2008, according to S&P/Citigroup Indices. On the other end of the spectrum is Latin America, which posts a relatively modest decline of roughly 6% in total return terms.
Finally, let's recognize that a recovery will eventually arrive. But when it does, and perhaps well before the upturn is obvious on Main Street, interest rates are likely to rise, perhaps quickly and sharply. Why? Inflation.
As we discussed the previous week, pricing pressure is bubbling. Falling commodity prices may take the edge off the trend, but it's not clear that inflation risk is about to evaporate. If there's a modest recovery later this year or in early 2009, the Fed will be under enormous pressure to hike rates. So, yes, there's reason to look past the current ills and consider the broader cycle, but let's not go crazy. There's no easy escape this time from the macroeconomic box that currently hems in the capital markets.