There is a likelihood of disturbing macro storm clouds for the S&P500 index above 1400
The year 2012 has witnessed a spectacular rally in global equities, commodities and emerging markets. The Wall Street S&P500 index is up by 25 per cent since October. Emerging markets like Brazil and Thailand have posted 35- 40 per cent returns. Now even the GCC stock markets have surged led by the near 30 per cent rally in Dubai's DFM. However, I believe that the bulls now exhibit the sort of classic "irrational exuberance" that invariably ends in tears. The geopolitics of the Middle East alone threatens another oil shock that could be as devastating to the global economy as the October 1973 Middle East war and the 1990 Iraqi invasion of Kuwait. Gasoline in some American states is already $4 a gallon in a $15 trillion economy where consumption is two third of GDP and household net worth was gutted by the housing crash and two bear markets in the past decade.
The current bull run should be called the "Ben- Super Mario- Masaaki" bull market because it was ignited by Ben Bernanke of the Fed, Mario Draghi of the ECB and Masaaki Shirakawa of the Bank of Japan. Their epic, unorthodox monetary policies slashed interest rates and generated at least two trillion dollars in high powered money that has inflated asset values in the financial markets. The epicenter of the global bull market lies in the US. However, I see disturbing macro storm clouds for the S&P500 index above 1400. Operating margins (ex Apple) have fallen even in Silicon Valley, meaning a $7 hit on index EPS is all too probable. The market cannot afford the luxury of earnings volatility now that American shares have doubled since March 2009 and the Chicago Volatility Index (VIX) has fallen to a mere 15. The stock markets is overvalued and overbought even as bond yields on Uncle Sam's debt have begun to rise. Bullish advisory sentiment is now at 48 per cent, near 2008 highs. Geopolitics, Iran war risk, the reelection of President Obama and fiscal tightening by the Republican Congress are all negative for the indices.
Fading fast
Apart from central bank liquidity, the global markets have attracted inflows from fund managers overweight cash who were increasingly attracted by the unmistakable strength in US economic data. After all, the economy has created 1.2 million jobs in the past six months, the best performance since the housing/credit bubble era of early 2006. Auto sales have surged to an annual 15 million units. Even the monetary doves in the Bernanke Fed have acknowledged the resilience in the US economy, a major factor behind the spectacular bull run since October. Yet the economic rationale for the bull market is fading fast.
One, US ISM manufacturing, German factory orders, Premier Wen's slashing of Chinese GDP growth estimates to 7.5 per cent, the ECB's bleak forecast for Europe growth will lead to a U- turn in macro sentiment in the next three months. This will be a disaster for global investor sentiment.
Two, Europe is the world's leading economic and trading bloc, the destination for 23 per cent of American exports, the source of trillion dollar daisy chains of cross border bank credit to Latin America, the Gulf, Southeast Asia. Europe faces not just a recession but a classic banking credit crunch that will gut the syndicated bank/offshore bond markets. The shock waves of the EU credit crunch will hit exports and corporate earnings from China to Brazil, from India to the GCC. The result? A wave of earnings downgrades that will devastate sentiment in the world's stock markets this summer. This scenario is simply not priced into current market valuations in either the US or the emerging markets.
Three, offshore fund managers have slashed their cash holdings as they scrambled to accumulate equities. This is the most dangerous point in the equity cycle since any hint of disappointment in earnings or economic data means the risk of significant sell offs.
Four, the Chinese just posted their biggest monthly trade deficit since 1989 (the year of the Tiananmen Square massacre, not exactly an export friendly event!) as the European debt woes hit the Middle Kingdom. The Chinese yuan forwards now suggest the end of hot money inflows. The PBOC will cut the banking system's RRR at least thrice and slash interest rates. This will be a negative backdrop for the high beta energy, metals and industrial shares which have led the current rally. There are a number of strategic trades that could make money for GCC investors if my macro scenario unfolds:
One, the two year US Treasury note yield cannot rise much above 40 basis points if the US economic data deteriorates. The Bernanke Fed will respond to weak data with stealth QE3. This means the two year T note yield can plunge. Two, take profits in GCC sukuk as credit spreads cannot compress when volatility and risk metrics in emerging markets rise. Avoid all unrated or deep junk sovereign debt. Reduce duration. Raise cash in GCC equities markets.
Three, as economic weakness will raise deflation risk, gold prices are headed lower. I would not be surprised to see gold trade as low as $1500 an ounce. Four, the Indian rupee is headed to the 53 - 54 range against the dollar.
The Congress losses in the state elections, no credible retail FDI or privatisation strategy, the impact of $125 Brent on the current account/fiscal discipline, wholesale inflation and the exodus of offshore funds from Dalal Street mean the Indian rupee will depreciate significantly in the next six months.
Five, now that the Greek bailout is over, the Swiss National Bank will become more aggressive in its monetary policies. This means the Euro/Swiss franc peg can well move from 1.20 to 1.26. The Swissie is also grossly overvalued against the dollar. I expect the Swiss franc to fall to 0.98 against the dollar and the Aussie to 1.02.
Six, the emerging markets index fund (symbol EEM) has risen from 34 in October 2011 to 44 now. Sell EEM at 44 for a 39 target. The easy money in EEM must now be banked.
© Oman Economic Review 2012
