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I don't think Monday was the beginning of a market bust--but the conditions for one are certainly out there
04/16/2013 8:30 am EST
I don’t think that a market decline like that of Monday or even Monday’s decline followed by similar drops for the rest of this week comes anywhere near a market bust or would add up to a bear market. The kind of bust I’m talking about s much more serious than a dip or a correction. Think Lehman Brothers. Not a retrace of 50% of the April rally.
But I do think the ingredients for another bust like the global financial crisis are out there. And I do think markets aren’t pricing in that possibility. And there is a connection between what happened on Monday and efforts by governments and central banks in developing economies to head off the chance of this kind of bust.
Anyway, when I put together my list of possible financial market busts on April 12 I did miss one.
An important one. The most likely scenario of all for a financial market bust in 2013 or 2014.
I want to hit myself over the head with a 2x4.
This bust scenario is one the markets have played out recently—within the last two decades, anyway. You can even see the beginnings of the bust in cash flows in global financial markets. And all you have to do is follow the money. The global central bank money that is.
Remember at the end of my April 12 post http://jubakpicks.com/2013/04/12/why-markets-arent-worried-about-inflation-even-as-central-banks-flood-the-world-with-cash/ I gave a brief list of possible bust scenarios that weren’t factored into the current rally in U.S. stocks or into stock prices in general. Central banks could produce a spike in interest rates when they begin reducing the size of their balance sheets. The Bank of Japan could produce a yen panic. The EuroZone could either break up in chaos or descend into a deep, deep recession. A run of bad loans in China could result in a government bailout of the banking sector.
All those are possible bust scenarios, I concluded, but the odds for any of them happening are relatively low.
But that list didn’t include the most likely bust scenario of all—one that actually seems to be increasing in probability now, although it is by no means guaranteed. It’s actually a scenario that we know can happen since it has happened before. And it’s one that, from that experience we know would be a big deal.
I’m talking about a replay of the Asian currency crisis of 1997—only this time the crisis wouldn’t be limited in scope to Asia but would take in—and could start in—any or all of the world’s developing markets.
I think I missed adding this scenario to my list of busts because I limited my thinking about the effects of central bank cash from the world’s developed economies to the effects on those developed economies themselves. But that cash doesn’t respect national boundaries. It can flow anywhere.
And the important question to ask is Where is all that developed economy central bank cash going?
It’s clearly not all going into developed economies. If it were, the U.S. recovery wouldn't be limping along and the EuroZone economy would have grown in the fourth quarter of 2012 instead of shrinking by 0.6%.
Clearly a lot of it is going into developing economies including China, Indonesia, Thailand, Malaysia and the Philippines.
For example, China’s reserves are on the march upwards again. The country’s reserves climbed by $198 billion in the first quarter of 2013. That’s the biggest jump since the second quarter of 2011. That increase is a sign, economists say, that China is again seeing big inflows of cash from outside its borders.
And the trend isn’t limited to China. Just in Asia it’s going on in Indonesia, Thailand, Malaysia, and the Philippines—in fact pretty much any place in the developing world that is growing faster and offering higher interest rates than the near 0% rates on offer in the developed world.
The upshot is not only an increase over cash inflows over those in 2012 but also an increase in 2013 of the rate of increase. Back in January 2013 the World Bank was reporting that gross capital flows into developing economies had climbed in the fourth quarter of 2012 to $170 billion, close to a record. That was a significant rebound from dips in the second quarter of 2011 and the second quarter of 2012. In January the World Bank also projected that capital flows to developing economies would increase in 2013 and 2014. Flows in January indeed climbed by 0.8% in January from the December levels.
But in March and April the World Bank’s reporting took on a new urgency. Gross cash flows in January and February, the bank announced, were up 49% from the January/February period in 2012. For the entire first quarter gross capital flows into developing economies increased 37% from the first quarter of 2012.
Back in October 2012 Citigroup reported that the timing of this increased cash flow into developing economies tracked very closely with the launch of the Federal Reserve’s new program of asset buying (Quantitative Easing 3 or something) in September. And that about 90% of the global total in these flows came from North America. So far, the early numbers show money flowing back into Japan with the start of the Bank of Japan’s more aggressive asset buying program. But I’d be surprised if we don’t start to see outflows from that country too as the program ages.
The effect of these cash flows has been, as you’d expect, rising asset prices in developing economies. In February real estate prices in China climbed in 62 of the 70 cities the government tracks. Prices in Beijing rose 5.9% from a year earlier and in Guangzhou 8.1% year over year. In smaller economies the effect has been even greater. In Indonesia, for example, real estate prices in Jakarta are rising at a 30% to 40% rate and in second-tier cities at a 50% rate.
All this has led institutions such as the Asian Development Bank to warn that with near zero interest rates, emerging markets threaten to be swamped by cash inflows. (You can find the bank’s January 2013 warning here https://www.moneyshow.com ) And it has led countries such as China to impose new curbs on the real estate market with a new 20% tax on profits in a sale, and higher interest rates and down payments for purchases. In addition China, Korea, and Taiwan have all intervened in the currency markets in order to slow or reverse the appreciation of their own currencies.
Why all this activity? In the short run developing economies want to avoid the kind of currency appreciation that reduces exports by making them more expensive for customers using other currencies. These economies may be growing faster than economies in the developed world, but they aren’t growing so fast that they aren’t worried about a slowdown in exports. They don’t want to see a stronger currency lead to a big surge in imports that could swing trade balances into the red. And they worry that all this cash could lead to an uptick in domestic inflation that would require stepping on the brakes to slow the economy to lower the inflation rate.
But I think it’s the longer run—and memories of the crisis of 1997-1998 that is driving government action. The trouble with big inflows of global cash is that this hot money can turn around and flow outward just as easily. In 1997 the flight of hot money from the economies of Thailand, Malaysia, Indonesia and other Asian countries led to the collapse of currencies across the region, a huge plunge in economic growth, and riots that brought down governments in countries such as Indonesia. The International Monetary Fund had to arrange a $40 billion stabilization fund. Governments in countries such as China had to intervene to rescue domestic banks from a flood of bad loans.
No one wants to go there again.
The danger this time, though, is that the measures required to combat the effects of global hot money flows may save the patient but only at a cost of a severe illness. Currency controls, efforts to slow domestic real estate markets, currency interventions to slow appreciation, reductions in bank and other lending to slow asset markets and the economy as a whole—all these can help avoid a replay of 1997-1998 in Asia and in non-Asian developing economies but the cost will be slower economic growth in a world that depends on developing economies in Asia and elsewhere for a big part of the relatively little growth it does have. A slowdown in these economies could rebound to slow growth even further in developed economies—which would only make developing economies even more attractive to global hot money.
The longer developed economies and central banks pursue their aggressive program of adding cash to the global financial system through big programs of asset purchases and their policy of near zero interest rates, the greater the danger that some important economy or group of economies in the developing world will either make a policy mistake or be forced into a major economic slowdown that inflicts short-term pain to avoid a long-term disaster. You can get an inkling—only an inkling though—of how this might hurt the global economy by looking at how China’s current modest efforts at restraint have hurt the markets for commodities such as copper and iron and the share prices of the companies that produce them. On Monday China’s National Bureau of Statistics reported that first quarter GDP growth came to just an annual 7.7%. That’s below the 7.9% annual rate in the fourth quarter and the 8% rate expected by economists surveyed by Bloomberg. And we all know what stock markets around the world did on Monday after China’s announcement.
Now imagine that the damage is both more severe and spread across more sectors—to include the makers of everything from luxury goods to cars to financial services.
I know, I know, just one more thing to worry about. Besides all the other things you need to watch in this potentially volatile market, in coming months I think you’ll need to watch real estate prices in developing economies, for signs that developing market governments are trying to slow growth, and for any increase in hot money flows into these economies that might produce even more aggressive currency interventions and send the world further down the path toward a period of currency wars.
This isn’t any time to get lulled into complacency by a U.S. stock market that until Monday anyway was hitting new high after new high. Participating in any extension of the current rally requires a worried vigilance as the price of admission.
Very little of this potential scenario, I’m afraid, is priced into the financial markets right now. That’s probably reasonable since I’d say this scenario is still a low-probability event. But even though it’s low probability now, I don’t think you should simply ignore the possibility. It is actually a bigger worry to me than the scenarios I laid out in my April 12 piece. Sorry that I missed it on that go round.
Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. When in 2010 I started the mutual fund I manage, Jubak Global Equity Fund http://jubakfund.com/ , I liquidated all my individual stock holdings and put the money into the fund. The fund did not own positions in any stock mentioned in this post as of the end of December. For a full list of the stocks in the fund as of the end of December see the fund’s portfolio at http://jubakfund.com/about-the-fund/holdings/
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