Faced with an avalanche of liquidity, US stock indices have scaled new highs. A sea of never-ending troubles in the Euro Zone as well as aggressive monetary easing in Japan (leading to a weaker yen) have contributed to a flight of capital from Europe and now, Japan, into US stocks, which have become the new risk-free haven of choice, replacing gold that has lost its sheen due to over-ownership.
S&P’s gain of 10 per cent this year has been outpaced by stronger rallies in healthcare, consumer staples and utilities sectors. These areas of market consist of high dividend-paying and defensive stocks, which are usually preferred by investors.
Lagging the broader market are industrials, technology and materials — sectors seen as barometers for global growth and usually providing the fuel that powers bull markets.
US stock performance looks like a by-product of artificially low bond yields and investors have bought defensive US stocks as bond substitutes.
S&P 500 is in uncharted waters even as copper continues to decline. Copper is used in everything, from houses and healthcare devices to tech gadgets. High copper prices are reflective of high demand and a robust economy, whereas rapidly falling copper prices raise serious red flags.
The breakdown of the traditional positive correlation between stocks and ‘Dr Copper’ indicates that global stocks are not reflecting true fundamentals.
GOLD MOVEMENTS
The recent dramatic drop in gold prices has coincided with the largest declines since 2011 in copper on a weekly basis and the largest decline of the year in the S&P 500.
It is indicative of the fact that quantitative easing measures by central banks are not entirely flowing through to investors, and the next asset class that could be vulnerable to heavy selling is equities.
In recent years, gold has rallied with new waves of ‘quantitative easing’ (purchases of bonds by central banks to push their yields down, a form of printing money). Prior to its crash, signs of trouble were beginning to show up.
Gold proved impervious to US Fed’s astonishing announcement last year of “QE Infinity” — indefinite bond purchases until employment begins to improve.
Gold failed to rally a month ago when the Cyprus situation threatened to engulf Euro Zone once again. It also failed to react to the extraordinarily aggressive monetary stimulus from Bank of Japan.
Globally, foreign exchange reserves (30 per cent of which are held by China) have fallen to their lowest level since 1999, just before the gold bull market started. Growth in reserves is — understandably — correlated with rising gold prices, so this was a sign that gold needed to fall.
FALLING COMMODITIES
Since the Dow Jones-UBS commodities index hit a post-crisis high two years ago, it has shed 25 per cent. Industrial metals are down 32 per cent and energy is down 30 per cent. Agricultural commodities have dropped almost 18 per cent (albeit with a sharp spike in 2012).
Falling prices for such commodities can be a symptom either of rising supply (as in the case of energy, where shale gas has eliminated talk of “peak oil” for a generation), or falling demand. Rapidly falling global growth seems to validate the latter. HSBC Chinese Purchasing Managers' Index for April has fallen to 50.5 from 51.6 in March, reflecting weaker global demand. A sharp drop in German business activity has overshadowed an easing downturn in France in April. Previously, we have seen Germany expand while Spain, Italy and France have contracted. Germany clearly forms backbone of the Euro Zone economy.
JAPAN’S STIMULUS
Investors in Japan are cheering the implementation of “Abenomics,” a fresh round of government spending and drastic monetary easing designed to end 15 years of deflation. The yen has depreciated sharply and the Nikkei is at multi-year highs.
Yet, Japan needs to implement plans to bring down debt, plus structural reforms to shift the economy into higher gear. Japan's gross public debt is projected to hit 230 per cent of GDP by 2014 after years of sustained deficits.
If Cyprus bailout is going to be a template for other Euro Zone nations needing a bailout, it surely does not bode well.
If deposits over €100,000 are not guaranteed in any Euro Zone nation, and if you’re in Spain or Italy, this surely is not a great outcome. Bank runs in those countries could reopen risk of collapse for the euro itself; a black swan event.
POLITICAL SITUATION
Major global stocks-centric risks could keep stocks markets on edge. North Korea continues to flex its muscles and could keep a lid on stocks.
Slovenia will likely grab headlines as the next Euro Zone nation to seek an international bailout. In the weeks following Cyprus bailout, Slovenia’s dollar bonds have dropped as worries about its troubled banking sector continue to simmer.
Attention is also likely to re-shift to prolonged political uncertainties in Italy, a country that remains ungovernable. This even as twice-elected Italian President Giorgio Napolitano remains confident of bringing a team of “wise men” to formulate reform measures.
Dalal Street appears to be factoring in a 25 basis point reduction in interest rate at the RBI’s May 3 meet. The steep fall in Wholesale Price Index (WPI) does make a case for interest rates to be reduced. However, India faces structural problems on food price inflation and supply constraints, which cannot be addressed by lowering interest rates.
Monetary policy decisions based on WPI inflation (ignoring elevated core CPI inflation and supply constraints) will be counter-productive.
A visit to a bookstore’s new releases section took me to a just-published book, $10,000 Gold: Why Gold’s Inevitable Rise Is the Investor’s Safe Haven . Once out of the new releases section, this book could be sitting pretty next to Dow 36,000 : The New Strategy for Profiting From the Coming Rise in the Stock Market , published in 1999.
Global stock markets are displaying irrational exuberance and a sharp correction is clearly on the cards.
(The author is CEO, Global Money Investor.)