ANDY's BACK!!!!!!!!!
Asia/Pacific: The Bear Market May Have Begun
Andy Xie (Hong Kong)
Summary & Conclusions
The four-year global growth boom and three-year bull market may be over. The liquidity boom has been manufacturing strong growth through asset inflation (property, credit spreads, commodities, and emerging market stocks). As inflation picks up, the liquidity boom and asset inflation will draw to a close.
Massive fund flows from the less experienced retail investors into hot-concept funds (for example, BRIC, commodity, India, China) have caused a global financial mania in the past five quarters. The mania has formed in an environment of sluggish global liquidity. Gravity has stopped the momentum, and we think the unwinding is likely to continue.
Inflationary pressure in the US and other OECD economies makes a cyclical bear market likely beyond the ongoing unwinding. Their central banks will tighten further and keep rates higher for longer than expected. Global liquidity could decline, causing risk asset valuations to contact.
As decade-long Anglo-Saxon consumption peters out, a secular bear market is possible. Asia is not ready to take over from the US as the global growth engine. China changing its development model to boost household consumption could be sufficient to support a bull market in Asia. But the reforms necessary to change the model may take five years or longer.
A financial hard landing is the most likely ending to the current bull market, in my view. An economic soft landing, however, is possible. A likely commodity burst would offer a tax cut to most economies in the world, while the commodity exporters sustain their demand with savings from the boom.
A financial crisis could trigger a global hard landing. Global financial markets look suspiciously like a pyramid game in this bull market. The proliferation of complicated derivative products catering to short-term trading strategies that aim to get the biggest bang for the buck creates massive uncertainty surrounding leverage in the global financial system. A commodity burst could cause correlation trades to unwind in other markets, which could snowball into a financial crisis.
The Mania Is Beginning to Unwind
When markets are hot, fund manager companies tend to market funds aggressively, especially ones with hot concepts. Commodity, BRIC, India, and China have been the hot concepts in this cycle. Tens of billions of dollars have been raised by such funds from the less experienced retail investors over the past three quarters in Japan, Korea, Taiwan, etc. This source of money has fueled rapid price appreciation in the recipient markets.
Starved of good returns in the US, long-term investors have been allocating funds to emerging market and commodity specialists to chase the good performance. Such funds have flowed disproportionately into small and illiquid stocks, causing them to rise multiple times. Their good performance attracts more funds and reinforces the virtuous cycle.
Rising leverage is another technical factor that has artificially boosted liquidity in the hot markets. Derivative products like warrants are a major factor. Some funds leverage up to increase exposure to high-beta assets.
The above technical factors have caused commodities and emerging markets to overshoot in the past three quarters. But, the overshooting has happened in a tightening liquidity environment. Global free liquidity G-3 short-term money growth minus G-3 nominal GDP growth rate has declined from 13% in 2002, 7% in 2003, 4% in 2004, to about 2% now.
A mania does not last in a tightening liquidity environment. The May sell-off indicates that gravity is working on this bubble. The unwinding is likely to continue.
Cyclical Bear Market Is Likely Beyond Mania Unwinding
The unwinding of the mania is still a correction. It implies that asset prices should return to the summer-2005 level, and rise in line with earnings growth afterwards. However, the emerging inflationary pressure in the US, Europe, and Japan may lead to more aggressive tightening by their central banks, which could cause liquidity to decline and asset valuation to contract, causing a cyclical bear market.
Global inflation is ticking back to the 1996 level after two deflation scares (1998 and 2002). The 10-year US treasury yield averaged 6.5% in 1996, and is now at 5%; the 10-year JGB averaged 3.2% then, and is now at 1.85%. Inflation matters because financial markets have got used to the disinflationary trend since 1998 and asset prices are positioned so.
The market is concerned, but has not priced in higher inflation rate yet. The monthly data fluctuate in a wide range. It will take several more months for the market to firm up its view on inflation. When the consensus embraces the view that global inflation is reverting back to the level in 1996 and that the unusually low inflation rate in the past decade is an aberration, asset prices could be re-priced significantly.
In addition, higher inflation rate will prevent central banks from cutting interest rates despite demand weakness. Australia has experienced a mild form of stagflation in the past two years. It could spread to other major economies. This would cause a proper cyclical bear market due to both slower growth and contracting valuation.
Secular Bear Market Is a Possibility
The Anglo-Saxon debt-driven consumption boom has been the demand background during the previous two bull markets. The cyclical bear market in 2001-02 cleaned the excess capacity in the IT sector. The excess liquidity flowed into emerging markets and commodities.
There are signs that the decade-long Anglo-Saxon consumption story is ending. Since the housing market turned in Australia, for example, its consumption has stayed anemic. The same is likely in the US. As long as housing prices remain weak, US consumption will not be strong.
Property markets have long cycles. The property bull market in Anglo-Saxon economies lasted for over a decade. The subsequent bear market could last as long. This would mean that the engine for global growth is gone.
Can Asia turn into a global growth engine or at least stand on its own despite a weak US economy? I believe that neither is likely. There is a demographic obstacle to the developed part of Asia (Japan, Korea, Hong Kong, Singapore, and Taiwan) achieving vibrant consumption growth. While Japan’s consumption is recovering, it is unlikely to be strong enough to offset the consumption weakness in the US.
If the US consumption stays low for many years, the only driver for another bull market in Asia would be China stepping up and producing consumption-led growth. China is well-placed for a consumption-led boom. Its household consumption is merely 40% of GDP. The ratio could rise to 55% without running into an inflation barrier, and there would still be sufficient savings to fund enough investment for 10% GDP growth rate.
The challenge is that China’s current growth model is geared towards promoting exports and suppressing consumption. The reforms in the past decade are biased against household income growth and towards an increasing household financial burden (for example, a rising household share of expenditure in education, healthcare, and housing). China needs to alter its development to achieve domestic demand-led growth.
The necessary reforms would take five years under the best circumstances. The excess liquidity in China’s banking system could delay reforms as it gives the government the means to support the economy through investment during a weak external environment. A ‘Wait it out’ strategy in a global downturn has worked for China over the past two decades. It will take a lot to change the government’s view. While China could eventually support a bull market in Asia, it will take time.
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