SERIOUS MONEY: THE CUNARD liner SS Slavoniabecame the first ship in history to transmit the Sierra Oscar Sierra (SOS) distress signal, as it encountered difficulty in the deep waters off the Azores on this day in 1909. More than a century later and the calm waters apparent in the world's capital markets since the autumn of last year have been disturbed by potential hard rocks and icebergs, from the rolling crisis in the euro-zone's periphery to political posturing over the debt ceiling in the US, just as the global economy has entered a soft patch and the lifeboat provided by the Federal Reserve via QE2 is about to sail into the sunset.
Stormier weather is apparent in the renewed volatility across most asset classes. Stock prices have declined in each of the past five weeks for the first time since the summer of 2008 – just before the major market indices entered a treacherous downward spiral that resulted in capital losses of more than 50 per cent – and almost all of the gains in the year-to-date in local currency terms have now been erased.
Commodities have come under intense scrutiny during the recent spate of selling and investors’ love affair with silver in particular came unstuck as the precious metal tumbled more than 25 per cent over the first week of May, its largest weekly drop since 1975.
Crude oil did not escape the carnage despite continued unrest in the Middle East and north African region, and slid some 10 per cent in a single session last month, among its largest daily declines in history.
The increase in risk aversion has also been apparent in the demand for safe-haven assets such as US Treasuries as well as the notable sector rotation within global equity markets. The yield on 10-year Treasury bonds has dropped three-quarters of a percentage point since the recent high in February, to below 3 per cent for the first time since last December, while the slope of the yield curve has fallen to its lowest level in six months. Meanwhile, equity investors have rotated out of cyclical sectors such as financials and consumer discretionary, and gravitated towards traditionally defensive areas of the market including healthcare and utilities.
The poor performance of risk assets in recent weeks provides an early warning as to what may lie in store for investors in a post-QE2 world.
The Federal Reserve is scheduled to conclude its $600 billion Treasury-bond purchase programme at the end of this month, and all the available evidence to date suggests that a further round of quantitative easing is not in the pipeline.
Unfortunately the countdown to the programme’s end has coincided with a troubling soft patch in the world’s largest economy. Real growth slipped to below 2 per cent in the first quarter and a batch of economic indicators in recent weeks suggest that the second quarter will not be much better. The latest prints for employment, wages and salaries, consumer confidence, purchasing manager surveys and home prices all fell short of expectations, while growth in the Economic Cycle Research Institute’s weekly leading index has fallen to levels that prompted fears of a double-dip recession last year.
The soft patch in the US has coincided not only with renewed tension in the euro-zone’s periphery, and an inevitable new financing package for Greece, but also a slowdown in growth across the emerging world from Brazil to China in response to the tightening of monetary policy. The slowdown has raised concerns that growth will suffer in developed countries such as Germany that have relied upon the developing world to provide a boost to exports.
The bulls will undoubtedly argue that the soft patch is temporary and related to once-off factors such as inclement weather or disruptions to the global supply chain arising from the Japanese earthquake and tsunami, such that the end of QE2 does not pose a material risk to the world’s financial markets.
However, it is quite clear that the Federal Reserve’s long-term asset purchases have been a primary determinant behind the surge in the prices of risk assets from commodities to stocks since autumn of last year. Indeed, even Fed chairman Ben Bernanke was quick to deem the central bank’s quantitative easing policies a success earlier in the year, based on the sharp advance in equity prices.
Sluggish growth in concert with the end of QE2 means the correction in risk assets is likely to continue. It is too early to tell whether the secular bear market is set to resume, but the increase in volatility alongside ambitious earnings estimates should ensure the shift away from small-capitalisation cyclical sectors towards large-capitalisation traditionally defensive areas of the market is sustained through the remainder of the year. Investors should take note and realign stock portfolios accordingly.
www.charliefell.com
