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August 21, 2009

Equities: Whats on the Horizon
by William Thomson

OVERVIEW

STOCK prices around the world recently hit their highest levels for this year, buoyed by a wave of optimism about prospects for a global economic recovery - only to fall back to a three-month low this week on fresh doubts about the sustainability of that recovery. So, is it 'for real' or is it destined to run out of steam? The Business Times empanelled a team of key experts to answer this critical question, and to tell us whether the world faces a threat of inflation, deflation or stagflation in the coming months. There were mixed views on the prospects for equity markets, but interestingly, everyone on the panel was bullish about gold.

Panellists

Mark Mobius, executive chairman, Templeton Asset Management
Eisuke Sakakibara, former vice finance minister for international affairs, Japan, and now Professor at Waseda University, Tokyo
Jesper Koll, president and CEO, Tantallon Research, Japan
The Hon Robert Lloyd-George, chairman of Lloyd George Management, Hong Kong
Ernest Kepper, former senior official of the International Finance Corporation (IFC) and Wall Street investment banker who now heads an Asian financial consultancy
William Thomson, chairman, Private Capital Ltd, Hong Kong and senior adviser to Axiom Funds, London and formerly a Vice President of the Asian Development Bank
Christopher Wood, managing director and equity strategist, CLSA Asia-Pacific Markets, Hong Kong

Moderator: Anthony Rowley, Tokyo correspondent, The  Business Times

Anthony Rowley: Let me start by asking: is the apparent recovery in the global economy for real, or a 'phony' one? And, are stock markets justified in behaving the way they have been doing lately?

Eisuke Sakakibara: I don't understand why equity prices are so high - in Japan the US and elsewhere. In China's case, there is obviously a very major bubble in the equity market. Also, I don't see any reason why the US Dow Average should be more than 9,000 (as it is now)or why the Japanese Nikkei average is more than 10,000. I just cannot understand it.

Ernest Kepper: This is a phony recovery. A turn-up in the economy is not the same as the economy recovering all lost ground. To keep rising in the future, markets need a sign of real economic recovery, and that requires a surge in consumer spending, business investment and home buying, combined with a reduction in government spending.

I fully expect to see the markets rise for a while longer, even as high as Dow 10,000 or S&P 1,100. After that, I think that we are going to see another leg down when the current rally ends, just as the powerful rally following the initial crash in 1929, ended up dealing out severe losses to those who held onto their shares.

William Thomson: In the wake of Lehman's failure the global financial system was staring into the abyss of a systemic meltdown. Governments then junked their economic philosophies and threw fiscal and monetary assistance at the problems on an unimaginable scale, just to keep things afloat. It has worked to the extent the system limps on and there has been a rally in the markets. But there has been no recovery in the real economy yet in the West. The pace of decline has slowed and the second half of 2009 could be modestly positive. But modest is the operative word since unemployment is likely to continue to grow well into 2010, reaching double digits even on the official count.

With housing foreclosures likely to keep climbing in the wake of extended unemployment, the consumer is likely to keep his wallet shut and try and repair his balance sheet. Modest economic recovery should continue as long as neither fiscal or monetary conditions become restrictive too quickly. But markets need a period of consolidation whilst they assess future prospects, so a broad trading range may be possible for the rest of the year. Dips can bought and rallies sold.

Anthony: Are any of you gentlemen more optimistic about the global outlook?

Robert Lloyd-George: This is not a 'phony' recovery. It may be slower and weaker than usual because of the debt super-cycle. But it is a real recovery - in trade, auto sales, consumer spending, corporate capital spending and so on.

We are 'climbing a wall of worry' because many economists (and hedge fund managers) do not believe in the recovery and still have 50 per cent cash, awaiting a correction, which may never come. Earnings, and GDP, figures will slowly improve and equity markets will strengthen well into spring of 2010.

Mark Mobius: The financial crisis was real in the banking system but not in the industrial economy. It impacted the economy because the banking system froze. However, markets are leading indicators and they are telling us the recovery is on the way now.

Jesper: I agree. There is nothing 'phony' about the recovery; globally, the policy response was swift and massive and very correct. Since the start of 2009, slowly but surely, global money and credit have started to flow again.

Markets have, of course, been pulled by the massive liquidity creation; the tell-tale sign was the US banks raising massive amounts of private capital this spring without much problem; and beyond financial companies, corporations in general have been very fast in cutting costs and slashing inventories. Many CEOs used the crisis as an opportunity to do all the harsh and hard things they had been wanting to do for years, but could not ; corporations are now mean and lean. Corporate profits for many companies are poised to explode in the coming two years; global stock markets are - right now - transitioning from a 'liquidity market' to an 'earnings market' ; in this phase, stock selection will become increasingly important.

Anthony: What is driving recovery in the markets - emerging markets especially?

Mark: In a word, money is what is driving the recovery. The money supply in most countries is rising at a very rapid pace. This money is finding its way into the economic system and is driving prices and economic activity. Added to this are the US$600 trillion in financial derivatives which amplifies money supply.

Jesper: In a word - growth. There is no question that the structural growth potential of 'Chindonesia' - China, India and Indonesia - is easily about two times, if not three times higher than that of the US, Europe or Japan. Even so, it will be interesting to see how long emerging markets sustain their growth premium. Valuations are now very stretched and if the US and Japanese recovery continues to gain visibility, these two markets could well start to outperform the emerging world for a couple of quarters.

Robert: Emerging Markets - Brazil, India and China anyhow - have clearly risen faster and stronger from the crisis, for good fundamental reasons - young consumers in hundreds of millions, and governments following ambitious infrastructure plans (in turn), driving demand for commodities.

Christopher Wood: Recovery is partly driven by the hope of a US restocking cycle and partly by the fact that Asia and emerging markets in general are becoming more domestic-demand driven.

William: We are in the midst of a historic shifting of economic power globally from a worn-out, complacent, over-leveraged, demographically challenged and decrepit West to a youthful, striving, high savings and increasingly well educated and confident Asia eager to take its place at the top table internationally.

Emerging markets cannot decouple completely in a globally integrated world but they do have greater flexibility to develop their own internal markets - as we have seen with the Chinese stimulus programme. This growth of emerging markets at the expense of the West is the story of the next 50 years.

Anthony: Let's focus on China especially for a moment since that is where most of the action continues to be. How do you see prospects in the China market?

Mark: Excellent. Chinese stocks have already gone up a lot and they will correct downwards but that will be temporary.

Robert: I remain bullish on China. Their macro-economic planning and management during the crisis continues to defy the Western pundits. They have plenty of cash (US$2 trillion reserves) and plenty of confidence. The younger generation will consume and borrow more. Economic relations with Taiwan improve. Overseas trade will recover. The renminbi is internationalising.

Jesper: China is one of the countries most exposed to rising cost pressures. Profit margins are already very thin, competition keeps intensifying across most sectors, and skilled labour is scarce. The key to success in the Chinese equity market will be an intense focus on stock selection - the gap between winners and losers is poised to widen sharply.

We will see the rise of true multinationals from China, true global players who do not just manufacture, but actually control the distribution channels and branding across the globe. These will be the real winners emerging from China over the next couple of years.

Ernest: China took aggressive measures to increase bank lending which in turn supported a strengthening of the stock market and is producing what looks like the start of a bubble, which the authorities are now trying to contain.

The Chinese government's stepping up bank lending was necessary but it's time for the excessive lending to be scaled back now. China's stimulus adds its own risk, including those of asset bubbles, overcapacity and non-performing loans.

Christopher: It is possible that the Chinese economy will grow by around 9 per cent in the second half of this year, after 7.1 per cent (year on year) growth in the first half of the year, due to surging public-sector and private-sector fixed-asset investment and resilient consumption. This assumes no real recovery in the West and a negative contribution to growth in terms of net exports. I am still overweight on China equities.

Eisuke: China will continue to grow at a fairly high rate of 7 or 8 per cent for some years to come and next year I think that China will be number two in terms of GDP.

That is only natural (because) China is a big country with a big population. China will need to emerge as a major economic power in the world.

William: The Chinese stimulus programme has been successful but the question is whether it is sustainable. It has involved a rapid expansion of bank balance sheets that could result in substantial losses a few years from now. As long as China's export markets stabilise then China's growth rate can be maintained at levels well above the West's rates. China recognises the old reliance on exports must change and it will. The real question is how fast that transformation can occur. Chinese equities have had a great run and are overdue for a breather but they have a core position in any long-term growth portfolio.

Anthony: Let's turn to wider issues. Is the world facing a risk of inflation as a consequence of all the liquidity that has been injected into economies, or deflation because of the global recession?

Eisuke: The global inflation threat is almost zero but there are some asset bubbles. If you think in terms of prices of goods, inflation fear is groundless but in terms of the prices of assets, there is a danger of bubbles in China, and even in Japan and the US. I don't think there will be hyper-inflation.

Robert: I expect inflation to rise within 12 months. Deflation is politically unacceptable in Western democracies and monetising debt is the only way out. This is very bearish for government bonds but mildly bullish for equities, property, and commodities, provided that inflation remains below 10 per cent.

William: We have been printing money like never before: the Fed's monetary base more than doubled in three months in late 2008. However, this has been going to fill up the black holes in balance sheets created by the credit implosion and velocity has dropped sharply. As a consequence it has yet to create inflation.

As things stand, we still need more quantitative easing and ultimately we need some inflation to reduce the real burden of our excessive debts. Renewed inflation would most likely come from currency depreciation especially the dollar which looks very weak at present and headed further south, possibly disastrously. I believe US government bonds are unattractive under such circumstances, selected equities are relatively more attractive, especially emerging markets on pull backs, as well as some commodities, including gold, silver and oil. Income producing property should also be attractive after the falls of the last two years.

Christopher: The risk in America and the West remains deflation. There remains almost zero evidence of re-leveraging in America.

Mark: Inflation is good for equities but not for bonds because bond rates must go up. Depending on how fast the money supply brakes are applied then the impact on equities could be positive or negative.

Anthony: While we're talking about inflation, the gold price continues its upward climb. Where is it headed and why?

Mark: Gold has probably already discounted a lot of inflation expectations but when hyperinflation hits then gold could move much higher.

Robert: Gold is going to a minimum of US$2,000 an ounce by 2011, in my view, for all the reasons above. World money supply has doubled in the last two years. No new gold supply, plus dwindling faith in 'fiat' currencies all around the world. Neither the dollar, nor the yen, nor the Euro will fill the bill.

Christopher: I maintain a long-term bullish view on gold bullion, with my long-term target price set at US$3,360 an ounce.

William: Gold has been tracing out a huge consolidation pattern since it first crossed the US$1,000 mark in March 2008. The demand for physical gold has been huge during this period of financial crisis as gold performs its familiar role of asset of last resort as governments around the world have engaged in unprecedented levels of quantitative easing. I am looking for a significant breakout to higher prices in the coming months: US$1,200 by the end of the year is not impossible with higher prices next year.

Jesper: Gold is the best hedge we have to the principal risk, which is inflation; so I like gold and also inflation linked bonds as a hedge.

Ernest: Psychology is the driving force behind the price of gold. Unless you have a clear idea who is going to come and rescue your portfolio of paper investments, owning gold and silver is important. Gold is still the only asset class which has risen in price every year since 2001. In fact, it is a bargain for gold to be selling for less than US$1,000 per ounce!

Anthony: In conclusion, what could go wrong to derail the present recovery?

Mark: Money supply has had fed the markets. Excess money supply begets inflation and that is what could go wrong but that is something we don't have to worry about for probably another year.

Robert: The only real problem I see is the high level of European government debt, which should not affect Asian markets.

Christopher: What can go wrong, and will go wrong, is that Western growth will remain anaemic in 2010 as a result of continuing de-leveraging.

Jesper: The biggest threat is inflation; if we get a new round of cost-push inflation we would be forced to call for a negative earnings cycle coming as soon as 2011. Another big threat is protectionism. Personally, I am hopeful this threat is low; I am very encouraged by the well coordinated response we have had to the global financial crisis, which suggests that global policy makers actually act rationally.

William: Many problems have been swept under the carpet and so a sustainable recovery to former growth rates does not seem to be on the cards for the US, the EU and Japan. The de-leveraging process still has a way to go and consumers, especially, have to continue to rebuild their balance sheets. Governments will have to restrain their expenditures and increase taxes, which will be neither easy nor popular.

Central banks also have to walk a fine line between taking away the punchbowl of quantitative easing and creating the fuel for future large scale inflation.

Ernest: There are two major things that could go wrong - the commercial property mortgage market and stimulus spending which could cause a bubble. Years of loose monetary policy has fuelled a dangerous credit bubble, leaving the global economy more vulnerable to another 1930s-style slump than generally understood.

Throwing billions of stimulus dollars at the banks is unlikely to produce a healthy economy because households are broke. At best, it may only lead to a temporary pickup in growth. Stimulus packages around the world are ultimately going to cause more damage than they prevent. These packages have simply delayed the coming downturn, and by adding significant numbers to the massive debt bubbles of the world's nations, will ultimately make the downturn worse than had governments not injected massive amounts of money into the economy.

When the (current) debt bubble bursts, the world will enter a serious downturn. The bailout is much bigger than the dot-com and real estate bubbles which hit speculators, investors and financiers the hardest. When the 'Bailout Bubble' explodes, the system goes with it because neither the US President nor the Federal Reserve will have the fiscal fixes or monetary policies available to inflate another bubble.

William R. Thomson
Chairman of Private Capital Ltd.

William Thomson, Chairman of Private Capital Ltd., an advisory company in Hong Kong. He is also a senior adviser to Franklin Templeton in Hong Kong and Axiom Alternative Funds in London.

Mr. Thomson is not a registered advisor and does not give investment advice. His comments are an expression of opinion only and should not be construed in any manner whatsoever as recommendations to buy or sell a stock, option, future, bond, commodity or any other financial instrument at any time. While he believes his statements to be true, they always depend on the reliability of his own credible sources. Of course, we recommend that you consult with a qualified investment advisor, one licensed by appropriate regulatory agencies in your legal jurisdiction, before making any investment decisions, and barring that, we encourage you confirm the facts on your own before making important investment commitments.

Copyright © 2001-2009 William R. Thomson

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