World Markets Simplified

 

 

 
It has been an eventful few weeks, culminating in the EU summit on Friday. The continued volatility in markets has tested the nerves of many an investor, and during times such as these it is important to look at the big picture trends and pay close attention to the views of market veterans. One such veteran, Jeremy Grantham, who runs the well known value fund manager GMO, published his "shortest quarterly letter ever" during the past week , which has some interesting observations on global markets. To summarise:

-His forecast of "seven lean years" of 2 1/2 years ago is being realised with a continuance of the large debt overhang, drop in asset values and general financial incompetence.

-In particular, the US and developed world is experiencing a permanent slowdown in GDP growth as result of slowing population growth, an aging profile and growing entitlements leaving inadequate resources for growth, together with a declining savings ate.

-In addition, an inadequate infrastructure, declining standards of education and ineffectiveness of government has made the US less competitive than other developed and some developing countries.

-Growth has also been held back by the growing inequality in the US leading to growing feeling of injustice, a weakening of social cohesiveness and a fall in the work ethic.

-Lack of income growth for the middle class has made demand more susceptible to changes in confidence and the willingness to take on more debt.

-The most critical long-term issues of depleting resources, a comprehensive energy policy and global warming have not been addressed in a serious manner.

-Looking ahead over the next year, the likelihood of bad outcomes are not as high as in 2008, but the possibility of extremely bad and long-lasting problems is as high as it has ever been.

-Yet the S&P 500 index has performed relatively well (compared to other global markets), driven by high profit margins and low inflation levels. Historically, these two factors are significant in determining P/E levels of the market and point towards levels which should be 20% higher if it were not for the numerous negatives facing the market.

-The S&P 500 index is unlikely to come down to its fair value of 975-1000 until profit margins decline. However, profit margins will eventually come down towards historical averages , dragging the market down with them.

-All major equity bubbles have broken below trend line values and stayed below them for years – the US in 1929 and 1965, Japan in 1989 – but the current market did not even reach the trend line in 2002 and took only 3 months to recover to the trend line in 2009. This is unprecedented and has been a result of the excessive stimulation of markets by Greenspan and Bernanke.

-Based on their study of the 10 biggest market bubbles (pre-2000) they calculate that it typically takes 14 years to recover the old trend line. With investors being conditioned to expect quick recoveries, an old fashioned downturn without the support of the Fed (whose arsenal is vastly depleted) could lead to a major decline in markets at some point.

-Following the market downturn in July, they found international developed equities , emerging markets and US high quality stocks to be relatively cheap with an expected 7% real return over 7 years. Despite the cheapness they remained a bit underweight due to the numerous negatives.

Recommendations:

-Avoid lower quality US stocks and remain near normal weighting in global equities.

-Have a bias towards safety.

-Avoid long term bonds and have enough cash on hand (and not be short-term greedy).

-Gradually build exposure to resources in the ground on a 10-year horizon. However, resources are likely to have further declines in prices due to a slowdown in China and better weather.

An insightful piece as usual - while pointing out the big issues facing the market, it does suggest maintaining core weightings in sectors such as US high quality, international developed equities, emerging market equities and commodities. At the same time, keep a reasonable amount of cash on hand to increase exposure on further market downturns. So stay the course, and try not to be incentivised to engage in either panic selling on downturns nor trying to pick the bottom to increase long exposure (as you are likely to be underexposed when the market begins to turn around). However, some amount of portfolio rebalancing when markets have big surges on the upside (to reduce long exposure) and on the downside (to increase long exposure) would be prudent.

The EU summit was an important event in that it set a long-term goal in terms of eventual fiscal union. This is a big positive as it does meet a key requirement for market stability – i.e. setting a long-term vision for the Eurozone. This opens the way for the ECB to play a more supportive role in the government bond markets , ranging from increasing its regular bond purchases in the secondary bond markets to quantitative easing (but a big bazooka announcement is unlikely unless market conditions warrant it). However, the actual path towards final stability is likely to be rocky as the finer details and processes are worked out over the coming months. Unfortunately, this implies continued volatility but, at the same time, the removal of a 2008 type meltdown scenario.

Have provided a chart below (from Soc Gen) which illustrates the relationship between the price of gold and the US monetary base over the last 90 years. This is the fundamental case for holding gold as part of diversified asset portfolio – as central banks across the world enter into further easing , gold is likely to continue to rise. So continue to buy on pullbacks!

 
European Union leaders agreed on new fiscal rules enshrining tougher budget discipline on Thursday, an EU official said, after the European Central Bank doused hopes of dramatic action on its part to arrest the euro area's debt crisis.

The 27 EU leaders, meeting in Brussels, agreed on automatic sanctions for euro zone deficit offenders unless three-quarters of states vote against the move, and approved a new fiscal rule on balanced budgets to be written into national constitutions.

"There is a deal between leaders on the new fiscal compact," an EU official told reporters after four hours of talks.

However, they were still debating how to strengthen their future permanent rescue fund and whether to give it a banking licence, and had not yet broached the vexed question of whether the new pact requires major changes to the EU treaty.

European Council President Herman Van Rompuy, the summit chairman, wants all 27 EU states to agree to the rule changes via a minor adjustment to a treaty protocol that could be implemented quickly without requiring full ratification. But German Chancellor Angela Merkel demanded a fully fledged treaty change to give the measures extra weight.

"The Germans are obsessed with how we are going to do things, saying we have to change the treaty. They are totally obsessed. That's why it can get difficult," an EU diplomat said.

ECB President Mario Draghi earlier spooked financial markets by discouraging expectations that the bank would massively step up buying of government bonds if EU leaders agreed on moves towards closer fiscal union.

As soon as the draft summit agreement leaked, a senior German official rejected key measures including letting the future rescue fund, the European Stability Mechanism, operate as a bank, borrowing from the ECB, and a long-term goal of issuing common euro zone bonds.

Draghi said the bloc's existing bailout facility should remain the main tool to fight bond market contagion, despite its clear limits. It was illegal for the ECB or national central banks to lend money to the IMF to buy euro zone bonds, he said, appearing to veto one firefighting option under consideration.

The ECB did take unprecedented action to support Europe's cash-starved banks with three-year liquidity and cut interest rates back to a record low 1.0 percent to counter a forecast recession brought on by widespread austerity measures.

The euro and world shares briefly rallied on news of the draft summit conclusions, only to fall back on the German rejection. Investors are increasingly convinced only the ECB has the power to protect the euro zone, and were disappointed by Draghi's caution on bond-buying.

"One step forward, two steps back," said Alan Clarke, UK and euro zone economist at Scotia Capital. "The euro zone leaders might as well not bother. Pack their bags, go home, enjoy the weekend and do their Christmas shopping."

French President Nicolas Sarkozy dramatised the danger facing the 17-nation single currency area hours before their eighth crisis summit of the year in a speech to European conservative leaders in the French port city of Marseille.

"Never has the risk of Europe exploding been so big," he said. "If there is no deal on Friday there will be no second chance."

France and Germany used the Marseille meeting to lobby for their plan to amend the European Union treaty to toughen budget discipline, which they want to have ready by March. But several countries are sceptical of full-blown treaty change.

Merkel said on arrival in Brussels: "The euro has lost credibility and this must be won back. We will make clear that we will accept more binding rules."

The new ECB chief said his remark last week that "other elements" might follow if euro zone leaders agreed to seal tougher new budget rules had been overinterpreted as hinting the bank could step up bond purchases.

"I was surprised by the implicit meaning that was given," Draghi said, without offering an alternative interpretation.

The ECB cut its main rate by a quarter-point and flagged a strong chance of recession next year. Draghi admitted the central bankers had been divided even on that decision.

The plight of Europe's banks was also thrown into sharp relief. The European Banking Authority told them to increase their capital by a total of 114.7 billion euros, significantly more than predicted two months ago.

A Reuters poll of economists found that while 33 out of 57 believe the euro zone will probably survive in its current form, 38 of those questioned expected this week's summit would fail to deliver a decisive solution to the debt crisis.

DIVISIONS
Before Draghi spoke, one euro zone source said negotiators were close to agreement for their central banks to lend 150 billion euros to the IMF for firefighting operations.

Although the ECB chief ruled out the IMF buying euro zone bonds, that left the option of lending directly to governments as it more customarily does, although Italy for one has insisted it needs no such assistance.

The EU remains divided over the need for treaty change. Van Rompuy is urging leaders to avoid a laborious full overhaul that could take up to two years and face uncertain ratification.

He wants them instead to slip stricter budget enforcement through in a protocol to existing treaties, a suggestion which infuriated Merkel.

If all 27 EU states do not support more fiscal union by adapting the existing Lisbon treaty, which took eight years to negotiate, then Sarkozy and Merkel want the 17 euro zone countries to go ahead alone with more integration.

Swedish Prime Minister Fredrik Reinfeldt, speaking for a non-euro state, said: "We want to stick with the 27 concept of course because all of us are members of the European Union and we want to have our influence. We want to keep the European project together."

However, he said there was no support in Sweden for treaty change as of now.

The Franco-German plan would slap automatic penalties on countries that overshoot deficit targets and make countries anchor a balanced budget rule in their constitutions.

"General government budgets shall in principle be balanced. Member states may incur deficits only to take into account the budgetary impact of the economic cycle or in case of exceptional economic circumstances," the draft summit conclusions said.

The sanctions could be stopped only if three quarters of euro zone countries are against them.

Not all euro zone countries are comfortable with all the French and German proposals, with Finland opposed to their call for majority votes on major policy decisions.

U.S. Treasury Secretary Timothy Geithner, ending a visit to Europe to urge decisive action with talks with new Italian Prime Minister Mario Monti, said it was essential for European leaders to strengthen their financial firewall to give economic reforms a chance to work.

Monti is pushing through economic reforms after the euro zone's third biggest economy found itself sucked to the centre of the debt crisis.

 
With Europe on the brink of collapse, economies all over the world (and in the U.S.) could only be a few short weeks away from TOTAL MELTDOWN! 

 
Returning to India from a summit in Bali last month, Manmohan Singh was cheerful and determined: once dubbed "the leader other leaders love", he'd enjoyed meeting Chinese Premier Wen Jiabao and U.S. President Barack Obama, one of his biggest admirers.

With a host of long-stalled reforms ready for debate in the next parliamentary session, he told a close colleague he was ready to get down to business.

"He came back very buoyant and wanted to show that he was in command," said the political insider, asking not to be named.

But there was little bonhomie waiting for the mild-mannered leader at home, where his blundering, corruption-plagued government has drifted into paralysis and he has been all but written off as yesterday's man.

What unfolded next was testimony to the crisis gripping his party, Congress, which has dominated Indian politics for decades with Gandhi dynasty leaders its lifeblood but now faces an uncertain future.

Determined to salvage his fading reputation as the hero of India's economic miracle and alarmed by mounting signs of economic stress, Singh moved quickly to announce one of the boldest reforms since he became premier in 2004 -- opening the country's $450 billion retail market to foreign operators.

He and his cabinet hoped the move would unleash desperately needed flows of foreign investment and help ease supply-side pressures feeding inflation, which is stuck near double-digits.

"He was really focused on getting things moving, and knew he needed to act," said the political insider.

But Singh's green light for supermarket giants like Wal-Mart Stores Inc (WMT.N) and Carrefour (CARR.PA) to enter India provoked an immediate and ferocious backlash from his political opponents, and even some of the ruling coalition allies on whom Congress relies to remain in power.

The firebrand leader of one of those coalition partners, Mamata Banerjee of the Trinamool Congress party, was reportedly so incensed with Singh that when he telephoned her to make his case for the reform she refused to take the call.

Within a fortnight, the government had capitulated and suspended the plan indefinitely.

POLITICAL MISSTEPS
The bruising retreat is symptomatic of the flaws of a political system where, over 15 years, coalitions have become the norm. Now, increasingly potent regional parties that share power can hold the government hostage to their demands.

A bitter partisanship has also emerged between Congress and its main rival, the Bharatiya Janata Party, that mirrors the obstructive politicking between Democrats and Republicans in the United States.

The BJP thwarted another reform proposal at a parliamentary committee meeting this week, according to media reports, rejecting a proposal to raise the limit for foreign direct investment in insurance companies to 49 percent from 26 percent.

However, Singh's clumsy handling of the retail reform plan was as much to blame for his failure to get it off the ground.

 
Expect More Exits Fortunately for Cameron, Sarkozy would not give into his demands. This makes Sarkozy the culprit even though Cameron handled the situation badly. The UK should take the next step and exit the EU and all of its nonsensical rules completely.The losers who stay in the proposed Merkozy treaty get the pleasure of forking over a collective $268 billion to the IMF. Expect the number who stay in to shrink. Then in May, unless the proposed treaty is further watered down, expect some of the 17 EMU (Eurozone) members to refuse to ratify the treaty.