Who do you want to believe, the cautious optimists who think the current rout in financial markets, especially stock markets, is just the sort of “correction” that happens in the middle of any recovery and that the US, at least, is in decent economic shape? Or the doom-merchants who think we face the start of a proper downturn?
The former camp’s case was set out lucidly by Dominic Rossi, chief investment officer for equities at fund manager Fidelity Worldwide. The lynchpin of the current turmoil is the strength of the dollar, he argues. When the world’s reserve currency inflates, the terms of trade change for everyone. The rest of the world, in effect, gets tighter monetary conditions.
What has prevented this happening until now, he argues, is the need for the US to get its budget deficit under control, plus the lavish helpings of quantitative easing. Both these factors are evaporating. The Obama administration, he thinks, will leave office with a fiscal surplus, having inherited a large deficit – that, in part, is the “peace dividend” from fighting fewer foreign wars. As for QE, it’s almost over in the US.
The key question, thinks Rossi, is to decide which countries and markets can cope with a stronger dollar. The sustainability of the US recovery is not in doubt, he thinks; some 200,000 jobs a month are being added; the housing market is strong; real incomes are improving with lower levels of inflation and lower fuel prices; the private sector is outperforming overall GDP growth of 2%; and the US Federal Reserve has freedom on when to raise rates.
It’s the rest of the world he worries about. The emerging markets’ export-led model has hit a wall as the countries in the west close their deficits, and the crash in the price of commodities is bad news for Russia, Brazil and South Africa. China may be close to its tolerable levels of debt. Europe is stuck in the middle, with economic pain coming from the east – Russia – and too much debt at the periphery. On the plus side, the euro is falling in value and the price of dollar-denominated oil is falling even faster, delivering a much-needed boost to competitiveness.
What will stop the market rout? Rossi’s answer is old-fashioned thirst for income. The yield on the S&P 500 index in the US is now 2.3%, which is better than the 2.1% available on 10-year US Treasuries. What’s more, dividends from US companies are rising at a rate of 10% in aggregate. He’s looking to buy US equities and expects the S&P 500, which has now fallen 10% from its top last month, to record a new high in 2015. In the UK stock market, the dividend yield is almost 4% “and that looks fairly stable to me”.
This, then, is the semi-optimistic – or selectively cheerful – view of the landscape. The “last remnants of the 2003-08 bull market are being swept away”, as Rossi puts it. That old bull market relied on Asian exports and delivered sky-high commodity prices; the new stock market leaders are technology, biotechnology, and intellectual property companies, which are concentrated in the US.
This plot seems perfectly plausible and is probably close to the consensus view among fund managers. So why doesn’t it feel wholly convincing? Aside from immediate worries like Ebola and geopolitics, there are three reasons:
First, the fragility of the eurozone. Five countries, including Spain and Italy, are already in deflation. Germany, the big engine, has caught a cold from Russian sanctions and the eastern wing of the eurozone looks even more vulnerable. In Greece, the yield on 10-year debt is suddenly back at 9%, suggesting investors are doubting European Central Bank president Mario Draghi’s pledge to do “whatever it takes” to protect the single currency.
That little cocktail could produce a nasty surprise in 2015. If outright recession is the result, a re-run of the 2011 crisis seems possible. Is a divided ECB even capable of delivering its own full-blown QE, if that’s what it takes? And are the eurozone’s banks now sufficiently robust to withstand any new storm in sovereign debt markets? The European Banking Authority’s stress tests on EU banks will be published later this month; too much honesty, or too little, could trigger fresh worries.
Second, it is far from clear that investors – despite umpteen warnings from the US Fed - are actually prepared for high US interest rates. Companies themselves may be awash with cash, but the financial sector may still be overdosed on cheap money and leverage. Nobody really knows how markets would react to the arrival, rather than the prospect, of higher US rates.
Third, how robust is the US recovery anyway? Yesterday’s industrial production numbers were strong – September’s gain was the biggest since November 2012 – but retail sales have been erratic. A rate hike could arrive at precisely the wrong moment.
The view here? The “correction” thesis seems correct on a medium-term view: we are miles away from the 2007-2009 banking crisis and, at some point, real dividends paid from real earnings by real companies should provide support to stock markets.
But in the short-term – say, the next six months – watch the eurozone. It is the dark cloud over the global economy that has proved impossible to shift. Recession in Germany would be a serious development and the worry is probably the biggest factor driving the market turmoil. In short, the eurozone could screw up everything.
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