Moorad Choudhry says tread carefull in 2010.
Investors worldwide would do well to be wary of the stock market rise since March 2009. One only has to look at the continuing virtual zero rate on 3-month US Treasury Bills to realise that substantial institutional investor cash remains firmly parked in the risk-free asset.
The “China effect” was in evidence this week, as both the Shanghai Composite Index and equity markets around the world fell in reaction to the Chinese government’s directive to its banks to reign in lending. Plainly the administration there is concerned about a growing asset price bubble and, given that cheap money is a prime driver of such bubbles, this makes sense. A slowdown in the Chinese economy would have knock-on effects around the world; it has become apparent that the linkage to Western economies is an influential one. We disagree with those who think that there is no asset bubble risk in the Chinese economy, the huge government fiscal stimulus in the wake of the global recession has done its job, but then pushed on and risks creating trouble of its own.
Will a reduction in liquidity caused by a slowdown in domestic lending have a negative impact on Western economies’ revival? The answer is most probably yes. But one can understand the administration there being concerned about the impact of too much cheap credit. Looking at the problem more analytically, we recommend that if the government is worried about overheating, an interest rate rise and an appreciation of the Renminbi would help just about everyone, but with these measures there’s politics involved…however an interest rate rise soon is not to be ruled out, although we don’t expect it this quarter. China is one more reason we expect a market correction…if there’s a slowdown there, it will be felt here make no mistake.
Lets discuss two issues of relevance for investors.
USD weakness…and strength
Recently the USD has become the “carry-trade” currency of choice, due to the virtually zero interest rate policy applied by the Federal Reserve. Right now the USD is the preferred funding currency for the carry trade, whereby it is borrowed and then sold against other higher yielding currencies with rising interest rates, such as the AUD. Falling dollar value against those currencies enhances the profitability of such trades as well.
However, at some point USD rates will rise. And at that point, the USD will start to appreciate. We need to remember that the dollar remains the world’s reserve currency and safe haven, and will remain so for the foreseeable future, regardless of any geo-political commentary from the Russian and Chinese governments. That does not mean that foreign investors will not switch part of their reserve holdings into other currencies, such as the euro. But we will not see the USD replaced as the unofficial reserve currency, for the simple reason that there is no alternative.
In 2010 the euro will start to show some weakness, against both USD and GBP, as the continuing problems in its peripheral member countries start to bite harder. We noted Greece and its public sector debt problem last week. In addition to Greece, euro-zone members Portugal, Italy, Spain and Ireland also have significant debt concerns. None of them can follow an independent monetary policy, and their fiscal stimuli and government borrowing are in danger of becoming unsustainable. Ireland and Spain have already suffered sovereign debt rating downgrades, which increase their borrowing costs, and more are likely. All this will only heighten speculation about a sovereign default or possible withdrawal from the euro-zone. While this is very unlikely, mere talk of it will depress the euro against the dollar.
The irresistible bull run in equities since March took some by surprise, but also led to some excess profits being generated by investment banks. Right now indices on both sides of the Atlantic are trading at very high P/E ratios, and this despite that corporate earnings, with the exception of certain sectors such as mining and commodities, have still not been restored to pre-recession health. What does this suggest? We believe that allied with a potential slow-down in China, it serves warning that a correction is due, perhaps in Q2 this year.
Bank stocks also look vulnerable. With certain notable exceptions such as Australian and Canadian banks, they are still repairing their balance sheets and this process is by no means complete. Add to that the higher cost of new regulations on liquidity and capital, and it implied that investors must be prepared for a changed bank business model. Restrictive bank regulation is replacing the laissez faire model. Higher capital requirements and other limits on risk-taking can be expected to curb bank profitability. So either way, as an investment sector banks are only a medium- or long-term play.
Moorad Choudhry is Head of Treasury at Europe Arab Bank plc in London, and author of Bank Asset and Liability Management, published by John Wiley & Sons (Asia) Pte Ltd.
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