What’s Next For Global Markets?

The US stock market has been a spectacular performer, up 17 per cent since its November sell-off after President Obama’s re-election.

This secular bull market in US equities and high yield credits was ignited and amplified by the epic $2.3 trillion expansion in the Federal Reserve’s balance sheet, stellar corporate earnings and a new wave of mergers and leveraged buyouts on Wall Street.

The rally is being led by the shares of money centre banks, beneficiaries of the US housing recovery, the recent Fed stress tests and “animal spirits” in Wall Street investment banking, despite the odd setback such as the London Whale and LIBOR manipulation scandals.

The US dollar has now become the strongest major world reserve currency, thanks to political risks in Italy and Spain, France’s budget woes, the public spat over the euro between the ECB and the Bundesbank, Japanese Prime Minister Shinzo Abe’s determination to devalue the yen, the weakness of sterling and the Canadian dollar. As the dollar rises, US equities become more attractive to European, Asian and Middle East institutional investors.

Financial markets are never linear and the nine per cent rise in the US stock market in 2013 is a case of too far, too soon. Despite the stronger February payroll data, the Federal Reserve has publicly stated that it will not raise interest rates as long as the unemployment rate does not fall to
6.5 per cent (now 7.8 per cent).

There is also no inflation concern in the US, with the CPI at two per cent. Corporate balance sheets have never been stronger. The equity risk premium is at seven per cent, meaning equities are not expensive relative to bonds.

In fact, the most overvalued asset class in the world is the bond market, particularly US Treasuries, German Bunds, British gilts, investment grade corporates, emerging market debt and MENA sukuk. The bond markets will price in a normalisation of interest rates far before the Federal Reserve tightens monetary policy. In fact, as the spike in ten-year government bond note yields demonstrates, this process has already begun.

There are clear signs of “irrational exuberance”, to use Alan Greenspan’s euphemism for an asset bubble, in the credit markets. Toxic exotica such as CLO’s PIK coupons and covenant lite loans, which triggered devastating losses during the crisis, have made a comeback. The most resilient niches of the debt markets are probably the bank floating rate loan market and Asian local currency debt.

The world economic milieu is now benign. The US economy is on a growth path, Europe is in a mild recession, Japan is determined to reflate and Chinese GDP is still near eight per cent, with emerging market growth solidly above five per cent.

The financial markets have priced out their worst case scenario, a hard landing in China, the breakup of the euro, another failure of a global bank. Fiscal reform in Washington, consumer confidence, a manufacturing renaissance, a surge in shale oil and gas production have all created benign backdrops for US asset markets.

What could derail the bull market on Wall Street? One, a new crisis in Europe if the new Italian coalition government abandons Mario Monti’s reform agenda. Two, a second credit rating downgrade on Uncle Sam debt if the Republicans and the White House fail to reach a grand bargain in entitlement reform before the end of 2013, as seems all too probable. Three, a geopolitical black swan.

The equities markets are no longer synchronised in 2013. Europe and the emerging markets have lagged the rallies in the US and Japan. In Europe, there
is clear evidence of austerity fatigue, illustrated by the meteoric rise of Beppe Grillo or Greece’s Golden Dawn.

I believe the winner in the emerging markets of 2012 will be Russia, China, South Korea and Thailand. India and Brazil have at least 15 per cent downside risk. As interest rates rise, gold could well fall to $1400 an ounce. However, there is value in Brent crude below $100. In the GCC, Saudi Arabia offers the best risk/ reward calculus.