Things To Bear In Mind As We Wait For The Bull To Return

The near-term outlook for global stock markets is for continued volatility, with little chance of sustained progress until we see an end to corporate earnings downgrades and an improvement in economic leading indicators.

In this note we comment on the problems facing emerging markets, and some broad thoughts on why capitalism remains a reasonable starting point for economic systems.

What is our market outlook?

The threat of a global financial meltdown has diminished thanks to massive central bank and government intervention, which has addressed the liquidity and solvency issues of many US and European banks. However, corporate earnings estimates for 2009 still look too optimistic in light of the poor economic leading indicators that we are seeing, such as consumer and business confidence levels. Therefore, sandwiched between the possibilityof an immediate short-term relief rally and a positive long-term view that equities are currently cheap, we have a near-term view that markets will remain volatile and are likely to trade sideways while the US, Europe and Japan endure a recession.

Emerging markets: the real threat would be a rise in global protectionism.

If the worst is over regarding the US and European banking crisis, it certainly is not for some emerging markets. Hungary finds itselfwith a massively over borrowed consumer sector, with foreign currencyborrowings in Swiss francs and Japanese yen. As these safe havencurrencies appreciate, the risk of widespread default on mortgages and other bank loans increases. The Ukraine economy is coming down with a bump as foreign lenders are put off by 25% inflation. Other emerging markets are suffering from a mix of problems that can include an overvalued currency, excess consumer borrowing (in local and sometimes foreign currencies), falling prices for commodity exports, domestic politics and a drop in demand for exports as the G7 enters recession.
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With little sign of a pick up in investor risk appetite, the near-term outlook is for continued underperformance for emerging market equities. But as investors pull money out of the asset class, P/E valuations are falling fast and some currencies are now appearing undervalued on a purchasing parity basis. Also, the long-term case for emerging markets remains in place: stronger productivity andGDP growth relative to the G7 economies, resulting in better long-term prospects for corporate earnings growth and share price appreciation. The only thing that will stop this, long term, is a retreat from globalisation by the G7 and/or the emerging markets themselves. Exports will slow down, competition in home markets will weaken as emerging markets raise tariffs on imports in a tit-for-tat measure, leading to weak productivity growth and lower GDP growth.

Fortunately the G7 does not appear likely to repeat the mistakesof the 1930s, when the US responded to the great depression by running a balanced budget, maintaining high real interest rates and imposing import tariffs. Indeed, it is interesting to note thatthe election speeches of both US presidential candidates have less protectionist rhetoric in them today than they did at the start of the year.

Capitalism remains the best method we have forallocating resources, just ask AynRand.

Few would wish to defend a completely unregulated dog-eat-dog version of capitalism, since this form usually destroys itself assuccessful companies become monopolies. But within a regulatedenvironment, with the accent on maintaining competition rather thansafeguarding producer interests, capitalism -through trade -hassucceeded in delivering the fastest increase in living standardsover the last 50 years for more people than we have known in history.The key is in its ability to find the right price for a given resource, whether labour, raw materials, money or time.

For the price to be an effective signal to producers and suppliers ofgoods, it must be ‘real’. By ‘real’ I mean a price that results fromcompeting suppliers and buyers in that market. If prices are instead influenced by government interference, over or under supply willresult, leading to wasted resources. Many governments have triedto ignore market prices, with taxpayers having to foot the bill forthe resulting subsidies and everyone suffering from the low productivitygrowth that occurs when government involvement in a sector prevents competition amongst suppliers. Indeed, the northern European countries that we perhaps most often think of assuccessful socialist countries are arguably prosperous because thestate by and large stays out of business and instead focuses onwelfare benefits.

For anyone who has become disillusioned on this point, and do not wish to wade through economics text books, I recommend as a tonic for your Christmas wish list the classic American novel byAynRand, ‘Atlas Shrugged’.

A word on dividends.

A reduction in corporate earnings may lead to a reduction individends, however history shows that the link is weaker than one might have thought. Dividends tend to fall much less than headline earnings, as companies like to have stable dividend policies where possible to encourage income investors. If necessary, companiesmay continue to pay dividends with very little cover if they believe they have strong enough balance sheets to afford such a policy.Banks and other financials that have recently taken government funds to recapitalise may see the sharpest dividend cuts as acondition of taking taxpayers money. Therefore the best performing income funds over the next year or so may be those that are widelydiversified by sector, invested in companies with strong free cashflow and with low exposure to financial stocks that may be underboth balance sheet and political pressure to slash their dividends.

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