Economic Watch

Market turmoil the beginning of something big

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“The huge volatility in global currency and equity markets is the first sign of something really big still to come – it’s the opening line of a movie of which no one knows the end.” (Read more)

These are the words of David Meades, economic historian, veteran financial journalist and successful portfolio manager on the JSE, in an interview with The Intelligence Bulletin.

A full-blown bear market like the present one on global markets, does not last only a few days, neither does it recover in just a few days, says Meades, who is working on a paper documenting the world’s investment history since the collapse of communism.

He hopes it will bring some perspective on an era during which everything around us changed dramatically, making it impossible for anyone to predict how things will play out in the end.

The impact of the totally new “economic game” that developed is so huge and the chaos it has created and thrives on, so omnipresent that many think it’s the new normal – despite everyone realising it is riddled with contradiction upon contradiction.

The developments surrounding the South African rand illustrate that what is happening is atypical in a historical context.

When South Africa’s rand fell to its previous record low in 2001, it fuelled export-led growth lasting until the global financial crisis. That isn’t happening now.

Four-years-plus of currency declines – to a fresh low last week – aren’t enough to offset electricity shortages, strikes and slowing demand from Asia and Europe, pushing the economy to the brink of recession. The very industries that should benefit from the rand’s slump are being hobbled.

South Africa is not alone in this boat. Besides most of sub-Saharan Africa and Latin America, Australia is heavily impacted with China accounting for about one-third of all its exports.

Even Germany – with exports to China accounting for about 2% of its GDP and exports leading its recovery after the 2008 crisis – will feel the impact of what is happening in the wake of the dramatic Chinese slowdown.

Only the US – with its strong currency, low inflation rate and with commodity prices plunging – is well positioned to deal with or even profit from the developing crisis.

Facts of the present

One of the cold facts of the present global environment is that in the Western section of the world of investment, South Africa included, equity price levels are largely determined by a small minority with billions at their disposal to manipulate markets at their will.

This is the case in most developed countries except in China, where equity prices in particular are determined by the masses, regarding markets as a vehicle to instant wealth. State banks supported them in chasing instant wealth without working for it – something that has been happening in the capitalist world for decades.

Share prices became highly over-inflated.

According to some estimates, 86% of participants on the Shanghai market are small investors, who in a bear market are reacting according to the herd instinct.

However, upward valuation of assets might in the short run bring bucketsful of unearned wealth, but not for everyone and not for ever, says Meades.

Some background

China’s economy is suffering from a combination of excessive growth, very selective use of capitalism and over-the-top state interference in the mistaken belief that it has found a magic formula to reconcile the best from two totally different systems. The penny has probably dropped that such a formula was not, and most likely will never be, found as the chickens come home to roost.

The first devaluation of the yuan was aimed at assisting Chinese exporters while the yuan remained pegged to the ever-strengthening US dollar.

Alarm bells went off when it became known that Chinese exports declined by 9% in July and the Economist suggests further devaluations of between 10% and 15% in the near future are possible.

China’s big fear is the anticipated September increase in US interest rates, destined to strengthen the dollar further while China needs to create work for its seven million new graduates annually.

“For decades I believed no country can devaluate itself out of trouble. But, things have changed – the old economy has passed while the new one is still battling to find its way through all the imbalances or unintended consequences that developed during the last decade or two resulting from China’s economic rising coinciding with tremendous decline of Europe and Britain – almost as if the one’s loss was the other one’s gain,” says Meades.

The new economy, developing since the second half of the 1990s, was characterised, markedly in the US, by the unprecedented rise in the power of capitalism as especially represented by big banks and Wall Street.

Normal market forces would have been able to deal with this situation but then came the 11 September terror attacks on the US. The US went onto a war footing. A threatening recession or depression made way for huge financial stimulation and quantitative easing.

Interest rates started coming down, no longer reflecting supply and demand factors but becoming exclusively an instrument of a symbiosis between monetary and fiscal authorities.

Instead of stimulating growth, the strong increase in the availability of liquidity only prevented the value of all asset classes from declining before starting to just go up and up.

A sign that US stocks had become overvalued was the fact that the price-to-earnings ratio, which measures a company’s current share price relative to its earnings per share, was approaching 19 to 20 times earnings – historically it averages 16.

China and Hong Kong’s markets were up against it over the past few months as the economy started coming down and it battled to deal with the imbalances resulting from its mostly closed economy. Despite free market claims and a mix between socialism and capitalism, in reality the state is in control of every aspect of the economy.

Over the years of massive economic growth the Chinese relied too heavily on investment aimed at stimulating export production and did too little to develop domestic consumer markets.

Exports grew to represent 65% of China’s GDP compared to the US where consumption represents 70% of its GDP.

Already in 2013 the Nobel Prize winning economist, Paul Krugman, warned that these kinds of imbalances in the Chinese economy would cause huge problems.

And now, the globe is in a vice grip of sluggish economic growth while in the West capitalism is battling to come to grips with its own imbalances.

These include issues such as the ever-widening gap in unequal distribution of wealth – something few realise is also a huge problem in China with its widespread poverty. It is indeed a bigger cause of concern among the Chinese ruling class than in democracies where the unemployed can attempt to improve their lot via the ballot box.

For China it is now of paramount importance to get its economy going again. The attempts to do so by an improved export contribution to GDP clearly were not successful.

While its devaluation will not have much impact on its inflation rate, it is rather confirmation that its flirtation with capitalism is collapsing. Its economy is now so huge – with a large part of it functioning in terms of own unique partially free market mechanisms – that state control is becoming increasingly difficult.

China is an economic superpower – not like the US or Europe, but big enough to really matter.

And it is facing troubled times. If its leaders are really that ignorant as it seemed in recent times, it is bad news, not only for China but for the rest of the globe as well, warns Krugman.

In the long run the Chinese government will lose the ability to control the animal it created, living somewhere between capitalism and socialism.

Probably a second inward revolution awaits China which could greatly set back its position as one of the biggest generators of global economic growth.

The London Telegraph speculated that the devaluations might be the start of the end game for the collapse of stock markets under the pressure of impossible expectations.

From China to Brazil central banks have lost control and the global economy is in danger of coming to a standstill and it is only a matter of time before stock markets buckle under the weight of record highs.

Earlier this year everyone were surprised when Switzerland suddenly after four years suspended the coupling of its franc to the euro, which resulted in a revaluation of the SF by 15%.

If that did not waken market participants to the fact that imbalances in financial markets were getting out of hand, nothing will.

In August the British stock exchange experienced its 77th week in bull territory, dating back to March 2009. Only two bull markets in history has had a longer run – the one before the collapse of 1929 and before the dotcom bubble went bust in 2000.

In the US Robert Shiller’s cyclical-adjusted price-income guideline, the ShillerCAPE, for S&P 500 is presently at 27.2, which is 64% above its historical average. It has only been higher on three previous occasions – 1929, 2000 and before the last financial crisis of 2007.

In South Africa the JSE All Shares index went to 55 000 before easing to 51 000 and then to 49 000 mid-last week, which is still astronomically high, adding up to a total market value of well over R11 trillion. Compare that to a GDP of R4.9 trillion and the market appears to be enormously overvalued.

Even when the international component is taken out of the equation (generously estimated at R5 trillion) it still leaves one with an adjusted market value of R6 trillion. This leaves one with market value of 120% of GDP compared to the US’s present 127%.

But one cannot remove the international component completely and a more realistic value would be closer to R8 trillion, translating to 158% market value compared to GDP.

The big question

The big question is whether conditions in the US and Europe can improve quickly enough for China to make gains there again, even if only partially so.

In this unfamiliar and unprecedented environment even the plans of the US to lift interest rates this month have been plunged into the uncertainty about its impact. One possibility is that it could prompt currency market speculators to start taking profits.

That in turn could see the dollar coming down strongly, spooking late entrants to the dollar market and prompting them to cover their positions, causing more dollar selloffs, triggering a new downturn phase.

It could destabilise financial markets across the globe. Just imagine what could happen to the rand if the dollar starts coming down. Its position should improve, triggering renewed interest in our markets.

At one point last week the markets in the US and Europe jumped up and down on the same day. This volatility is going to be with us for some time. The last reel of the movie has started but no one knows when and how it will end – there might be a sudden death or it might last for years.

Thus it should have come as no surprise when the Chinese stock market started to collapse last week and the rest of the world followed suit, with what is now referred to as Black Monday. The Chinese brought interest rates down again on Tuesday and markets started to recover. But this is no cause for jubilation. The stock markets of Shanghai and Hong Kong are technically still in a bear market and most other markets still in correction mode. Bear markets don’t end in days.

The prudent investor will, if he or she has not done so yet, prepare for a tough winter, says Meades.

by Piet Coetzer

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