MARKET OBSERVER – N° 117

The last quarter of the year was extremely negative for the global stock markets with the month of December which recorded, for some indices, the worst result of their history, including the Great Depression period. To quantify, during the Christmas week, the S & P 500 index lost more than 8% and for the month lost 10% only thanks to a modest technical rebound during the last sessions of the year.

For the year, the international stock markets show almost only double-digit negative performance, with the exception of the United States that limited the damage, while in Europe it ranges between -10% of the Zurich Stock Exchange, to -18% of the Frankfurt, Nikkei lost 12% in Tokyo, the index in Hong Kong sacrificed 15%, in Shanghai the Chinese exchange lost more than 20%, Moscow 15%; the exception being only a few bourses for contingent reasons such as Brazil which was up by 14% and India with a gain of around 6%. If we consider that in January all the exchanges had a nice run, quantifying the fall in the markets with respect to the annual highs the losses increase in some cases between 5% and 10%, like the Milan stock exchange which shed 25%. The acceleration of the bearish phase, which took place on the Asian and European markets between February and May, occurred with the sudden collapse of Wall Street, which after recording a new historical high on September 20 at 2930.75 points of the the S & P 500 index lost almost 3% on 10 October due to the late reaction to the umpteenth increase in the guide rate decided by the Fed on 25 September.

In fact, starting from 3 October, in a few sessions the yield on ten-year treasury securities rose from 3.08% to 3.24%, causing a massive transfer of assets from equities to the bond sector. This sudden change before us is evidenced by the sharp rise in equity volatility that saw the implied S&P 500 deflator, the VIX index, triple in value during the last quarter. At that point the Pandora’s Box was opened, in the sense that the equity investors in the face of short-term bond yields of 2.25% and long of 3.25%, could no longer consider the valuations achieved on the stock exchange to be justified. But if this is the trigger for the generalized bearish phase, the analysis of the cause-effect factors set in motion by the improper monetary policy implemented by the main central banks, and not only by the FED, from the beginning of the year is much more complex. This maneuver would have already drained more than 1100 billion dollars from the financial systems, only the Fed absorbs 50 billion a month, to which are added about 3000 billion contraction suffered by the overall liquidity of the private sector; that is corporate treasuries and savings. It could even indicate similarities with what occured between the summer of 2007 and the spring of 2008, when both the US central bank and the ECB decided to make sudden increases in base rates, exacerbating the effects of the banking crisis in autumn 2008 Fortunately, thanks to the marked reduction in financial leverage that has been reduced by 2/3 in the past decade, a similar scenario can be excluded, while a traditional bear market phase looms, therefore lasting 15/18 months from its start, which, depending on the exchange, is between February and September 2018. Therefore, those responsible for international monetary policy have again fallen into error, having not learned enough from the aforementioned episode, neglecting to consider that the developed economies remain in a long-term structural deflationary phase while the emerging ones are in a disinflationary phase.

These are the long-term consequences of the globalization process of the world economies, which sees the fall of the Berlin wall as a trigger for the industrialization of the emerging economies, in particular – the Chinese economy, which have dramatically increased the production capacity in a context of stagnant demand for a decade. In fact, it is sufficient to examine the trend of world-wide consumption indices to realize that this rate averages 2%, despite a decade of marked liquidity introduced by the base rates at or under zero in many developed economies and close to historical lows in emerging economies. In essence, the “Japanese syndrome”, that has existed for three decades, has infected the entire world economy in different ways, it seems that the rate of inflation in China was 2.1% in November. So the rash decision made at the beginning of 2018 by almost all major central banks, with the exception of the Chinese CB, to restrict credit by increasing rates rather than reducing its balance sheet, finds no justification in the inflationary dynamic, while contributing to aggravate the cyclical cooling that started in Europe and Asia, posing serious questions also on the continuation of US growth. This doubt is all the more credible if one examines the dynamics of long-term rates offered by the dollar, from 3.25% in October to the current 2.65%, with the consequent flattening of the yield curve, given that the ninth consecutive increase of the base rate from 2015, has brought us to 2.5%. This flattening is partly explained by the sharp decline in investors ‘risk appetite, witnessed by the fall of stock prices, which increases the demand for safe-haven financial assets, such as US government bonds, but above all derives from the investors’ conviction, which is that a recession is on the horizon and therefore interest rates are expected to fall. The working hypothesis presented by the Governor of the Fed, of two other increases in the base rate during this year, could therefore turn out to be fallacious, opening a wall of worry also on the prospects for the dollar. Regarding the work of the FED, it is interesting to expound on the reasons that led President Trump to publicly attack Governor Powell, appointed by him, on the decision to increase the base rate, a move that has created concern on the securities markets, helping to accentuate the stock market decline. The suspicion arises that the President with this stance and above all with the scenario in progress for the financing of the wall with Mexico, which caused the stall in the approval of the Federal Budget, has deliberately forced the stock market downturn, with conjunctural consequences, having all the time before the presidential elections of the end of 2020 to save the situation and present himself to the electorate in the spring of that year as the architect of the recovery. Given the situation that has arisen, the global stock markets have the only option remaining of rapidly adjusting the valuations of securities to consider the changed prospective economic scenario that indicates downward revisions of the 2019 GDP of almost all the developed countries. In some emblematic cases, such as Japan, Germany and Italy, there are serious probabilities that these economies are already in recession, if the definition of two consecutive quarters of GDP declines is applied. We are therefore in the presence of a cyclical downtrend, to be considered normal, with the termination of two programs of monetary stimulus implemented to mitigate the consequences of the great financial crisis of 2008. From a quantitative point of view, these contractions can be between 30% and 50% from the highs made by stock indices. Assuming that the timeframe to be evaluated is the one that has elapsed from the 2009 lows to the present, the best-case scenario sees the US S&P 500 correcting to the 2200 / 2000 level, while the EuroStoxx 50 index could come down towards around 2750 points, having already broken the 3100 level; the correction level of 30%. It must be considered that these bearish phases may be accompanied by marked technical rebounds favored by the oversold situation, accompanied by contingent news, such as the approval of the US budget or an agreement on tariffs with China, to be used for lightening positions. In fact, the underlying trend will remain dominated by selling until the cited technical objectives are reached or the fundamental framework, in particular monetary policy, will not undergo radical changes. In fact, if the decline was generated by the scant decisions of central banks, the same could run for cover in short order, reversing the trend already before summer.

Given that the Fed has anticipated the monetary stimulus belatedly implemented by the ECB by almost three years, we could already be at the peak of the dollar’s base rate. It will take a few months to get feedback on this decision, but this thesis implies not only that there will be no further increases, but even that the rate on funds of the US Federal Reserve can return to 1.5% between 2019 and 2020. In fact, to confront the possibility of recession, the FED will have to positively incline the yield curve by reducing the short-term rate already this year. To verify the credibility of this thesis, it will only be necessary to monitor the next sequence of monthly macroeconomic data on the US economy, exactly what the FED intends to do. This situation favors a return to medium-term bonds, especially in dollars, but having the foresight to hedge the exchange risk, as the expected economic scenario disadvantages the greenback, especially if the support at 1.17 share compared to the Euro is broken. The cost of the hedge is offset by the coupon offered by the bond in dollars, so the benefit is derived from the net capital gain in Euro. For stock exchanges, to be executed mindful of the indicated technical levels, or to the emergence of indications that monetary policy will once again be expansive, a strategy of qualitative revaluation of portfolios should gradually be implemented, eliminating the lower quality securities, to be replaced by large capitalization shares issued by primary companies, as the bearish phase did not make distinctions in penalizing the two equity classes. It is also worthwhile to start to carefully consider the financial sector, back from a very tough 2018, which has a strong potential for appreciation if the yield curve inclines further. The working hypothesis foresees that in the second half of the year the stock market indices will be able to return to the upward trend, thanks to the expected repentance by the monetary authorities. On the currency front, it is interesting to note the absolute stability of the value of the dollar, which has not undergone any change despite the nervousness of the stock exchanges, unlike what usually has occurred in similar historical phases. On the contrary, if we consider the parity of the greenback to the yen, which together with the Swiss franc is a safe haven, a sudden loss in the value of the dollar can be witnessed. Although the Bank of Japan has momentarily stopped its strategy of pegging the exchange rate of the Yen to the US currency, not being able to counter the strong demand for Yen induced by the nervousness of international investors, this slowing of the dollar must make us reflect. In fact, it could be a prelude to its generalized decline, when the hypothesis of a cooling down of the US economy might gain credibility; it is advised to monitor the support level at 1.17 to the euro.

The Swiss franc was also very stable, near the recent highs for the period, but could strengthen further due to the fears induced by the probable continuation of stock market declines. The moderate recovery of gold in the second half, which allowed the value per ounce to return near the level at the beginning of the year, deserves attention as it occurred in concordance of a strengthening dollar. Investors probably believe that the prospective economic downturn will reduce the opportunity cost of investing in gold via a reduction in interest rates and therefore it is likely that the metal will continue its gradual rise accompanied by mining stocks.

Nicola Bravetti Data Source: Bloomberg