Since bottoming at the end of October, the MSCI Emerging Market Index (MXEA) and MSCI Asia Ex-Japan ...
A Look Back to See What’s Ahead
09/06/2011 11:30 am EST
August was a terrible month for markets, and an even worse one on the political leadership front, write David and Eric Coffin of the Hard Rock Analyst.
Markets have suffered the worst dive since 2008. The markets’ direction going forward is very much dependent on traders believing politicians can get ahead of the curve and “deal with” debt issues in the US but especially in Europe.
Major indices in North America flirted with “bear market” drops of 20%, and several large exchanges in Europe and elsewhere have already seen drops of that much and more. Traditional indicators of fear across the markets, including Treasury yields, volatility readings—and, of course, the gold price—have been pushed to extremes.
While many of the debt troubles can be traced back to the 2008 debt crisis, politics have become the heart of current market issues. So far, politicians have proven to be inadequate to the task at hand. This does not bode well for the markets or the economy, unless there is a sudden outbreak of stiff backbones and cooperativeness in the halls of power.
Leaders across the G7 (the ones not at their cottages, at least) have insisted they were prepared to do whatever necessary to stop debt contagion. A nice sentiment, but—like many similar pronouncements in recent weeks—it included no concrete plans.
Lack of direction or a roadmap out of the current crisis is keeping markets on edge. Rumors of weakness at various large financial institutions are easily peddled, widely believed, and traded viciously.
So far, the soothing has been left to central bankers. The European Central Bank has been the most forthright and active. The ECB has been buying up Italian and Spanish government debt to push those yield curves down.
That was a brave move on the part of Jean-Claude Trichet. It’s no secret that several members of the ECB board were screaming foul about that trade.
So far, it’s also a move that has worked. Yields on ten-year Italian and Spanish bonds have dropped 1.5% in the past two weeks. Two-year notes issued by the Italian government on August 10 bore a 2.96% yield, 71 basis points below the yield on a similar auction a month ago.
In the US, it was left to Ben Bernanke to do something definitive, if not dramatic. At last month’s Fed meeting, Bernanke put a timeline on the “extended period” of low rates, promising to keep the current rate in place until the middle of 2013.
This made markets happy for a couple of hours, though it too drew catcalls from some. The move does take away a lot of flexibility from its actions. We’re not sure how good a thing that is.
The Fed already has constraints with such a dysfunctional bunch of politicians in Washington. The Fed board could still increase its balance sheet, but many of the stronger actions it might contemplate would need political cover that isn’t likely to be forthcoming.
There are several inflation hawks on the Fed board to satisfy. They won’t be happy about the latest 0.5% CPI increase. We think some moderate inflation is the best thing that could happen to a debtor country issuing chits in its own currency. Inflation is the most painless way to debase the debt, even if it’s a genie that’s hard to control once it’s out of the bottle.
In the US, down-to-the-wire debt ceiling negotiations combined with a cynical and ineffectual last-minute agreement weakened the markets considerably. The big losers on both sides of the Atlantic have been the banking sector, though selling is broad-based.
The debt issue is far more serious in Europe, but the confidence issue is the same. Aside from the PIIGS, most European countries have debt-to-GDP ratios that are manageable, though not low. Most are lower than the US, for that matter. The real task in the short run is to convince markets that issues will be dealt with and not glossed over.
The only cure for this kind of situation is time and enough action by the political class to decrease uncertainty. If the large economies are still growing, it will show up in the numbers, with US employment and consumer spending being the most heavily watched. Only time will tell when confidence lost during the past weeks of political farce will return.
On a positive note, market weakness has affected energy prices substantially. A $40 a barrel drop in oil prices is a good tailwind, particularly for the US, if prices stay down.
Also good are strong growth numbers out of China and India. Beijing is (finally!) letting the yuan rise. If that continues, the increased purchasing power would do a lot of good. With China’s current inflation rate, a new bout of government spending like late 2008 is very unlikely.
One thing different (so far) about this market drop is that resource stocks—especially juniors—have not been harder hit. The percentage drop in the Venture index since late July is less than the S&P. If you’ve been through a few cycles like we have, you know this is very unusual.
Gold prices are the main reason for this, of course. Unlike 2008, many have taken refuge in the gold market this time, running the price past $1,800/ounce. [And $1,900 in early trading Tuesday—Editor.]
A lot of it is fear buying. If the markets manage to calm themselves, a pullback in gold prices is a reasonable expectation.
We don’t expect a massive drop. There is plenty of “disgust” buying along with the fear purchases. Its impressive how poorly the US dollar fared, given the massive flows into the Treasury market. Some of that distrust will remain, and support gold if it eases back to recent highs in the $1,600 to $1,700 range.
NEXT: Outlook for Silver and Bulk Commodities|pagebreak|
Silver’s industrial side kept it from matching gold’s gains this month, and the same is true for Platinum and Palladium. It’s not as countercyclical as gold. If the markets calm, it may outperform gold in the next while.
Things were anything but rosy for the red metal. Copper got pounded hard right along with equity markets. We’ve expected a pullback even before major markets crashed.
The speed of the downside move was impressive and it looks like a lot of longs have exited the market. The copper price is getting closer to reasonable, but if markets fall harder, copper will fall with them.
We see no point in getting brave about copper equities until the markets sort themselves. The same holds for other base metals.
So far at least, bulk minerals like Potash and Iron Ore have been almost unscathed by the crisis. Both moved up in price, but that won’t help producers and explorers in the bulk mineral space. The pro-cyclical nature of these stocks is so ingrained that they will recover with (and only with) the larger indices.
We’d love to give you a definitive target for the major indices, but to do that we would need to literally be mind readers. At a big-picture level, a lot of the bad news is out there unless we encounter a “Lehman moment.”
From here, forward growth—or lack thereof—in the major economies will determine the direction of markets.
A return of confidence depends on citizens believing things won’t get worse. That requires a greater sense of stability and purpose than politicians on either side of the Atlantic have delivered.
If everyone acts on the assumption crises cannot be controlled, then we will have a recession sooner rather than later. It’s no more complicated than that.
Gold and discovery can help cushion things if some stability returns. There are not many bolt holes if it doesn’t—though gold and gold stocks would be the best of the worst.
The market will be a very dangerous place for the next few months, even in the best case.
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