Stimulus, Storytelling and Bouncing Bears

飞雪寒冰

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.

飞雪寒冰

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.

飞雪寒冰

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.

飞雪寒冰

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.

飞雪寒冰

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.