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Money Feb 20, 2012

Sell this rally: We’re not out of the woods yet

By Vatsal Srivastava

Good things take time. This holds true even for the global economy and financial markets, which are coming out of the worst downturn since the Great Depression of the early 1930s.

An overwhelming sense of optimism and self-assurance over near-term prospects has made the New Year rally last longer than most would have expected with the bears either having been stopped in their tracks or waiting on the sidelines for technically overbought levels.

The MSCI world index is up more than 7 percent since the start of January. Reuters

The MSCI world index is up more than 7 percent since the start of January, the broad-based S&P 500 is trading near 2011 highs at 1,360, European markets have staged a strong up-move with bond yields in debt- ridden peripheral economies touching three-month lows and the major underperforming markets of 2011 -- India, Greece, Turkey, Egypt and Hungary -- topping the equity returns table in the new year.

The main propellants of this global rally were better-than-expected US jobs data, the US Federal Reserve's mandate to keep interest rates near zero well into 2014, the likelihood of a Greek default looking less likely and strong purchasing manager's index (PMI) data out of Europe.

So is the worst behind us?

Are we on the verge of a new bull market? It seems unlikely.

In Europe, growth is negative not only on the periphery but also in core economies. German exports contracted 4.7 percent (month on month)in December and 5.6 percent quarter-on-quarter in the last quarter of 2011, in real terms. The euro has also been strengthening of late, which would make it hard for the eurozone to restore competitiveness.

Additional fiscal drag is still in the pipeline as austerity measures are still in their early stages of implementation.

The euro-zone is also on the brink of a severe credit crunch as banks are deleveraging -- a lot of this may be done via asset disposals and credit contraction. The January European Central Bank lending survey suggests that on a three-month rolling basis -- the rate of credit growth relative to GDP is contracting significantly more than what was seen during the post-Lehman collapse period in Europe.

The outperformance of US data relative to global data has started to decline in January after peaking out in December last year according to the Goldman Sachs global leading indicator series.

As economists and analysts revise their forecasts upwards, any misses on the better than expected data going forward will probably take the markets lower.

Capital expenditure will most likely remain subdued in 2012 as tax benefits like accelerated depreciation allowances expire and capacity utilisation rates remain low across corporates. Home prices are expected to fall further in 2012 as the supply of new and existing homes is still more than demand even after six years of a housing recession. It is estimated that 40 percent of US households with a mortgage will be in negative equity by the end f this year.

Residential investment as a share of GDP is now down to 2 percent, well below its bubble peak of 6 percent and will not make a major contribution to economic growth. Another round of quantitative easing (QE3) is partly priced in the equity markets. Also, this time around, it won't lead to a weaker dollar, which should boost US exports as an ultra loose monetary policy has been adopted by many developed and emerging market central banks.

In Asia, Japan's economy contracted at a more-than-expected 2.3 percent quarter-on-quarter (annualised) in the fourth quarter of 2011.

In China, export growth is slowing sharply and fears of a real-estate hard landing are still on the table. India's growth is expected to be 6.9 percent in 2012, which would be its worst performance since 2009, the peak of the financial crisis.

Add to this the surge in energy prices, especially oil, which closed above the $104 level on Friday. There is nothing to suggest that oil can't move towards the $120 levels due to geopolitical tensions in the Middle-East. In fact, the oil bulls are banking on supply disruptions. Net speculative long positions in Nymex crude are at their highest level since last May.

The trend is your friend until it bends. We should remember this golden rule and should not be surprised if this rally still has legs and takes us higher still. But, at some point of time, fundamentals will catch up. A correction is on the cards and it's too early to say we are entering a new secular bull market.

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