After having suffered the worst May since 1940 (Dow), equities have continued their sell-off into early June, amidst concerns about spreading European debt crisis, Chinese tightening and fading US recovery. The rally off the March 2009 lows was driven by liquidity, stimulus and improving economic and earnings data, particularly in the US. Now that government stimulus starts to taper off the question is whether economic growth has become self sustaining or not.

A natural slowing in the second half of the year has been expected. However, concerns about a double dip recession now appear to be growing, given the sovereign debt crisis and contagion risks in the eurozone and Europe’s impact on the global economy as countries start implementing austerity measures. Add concerns about Chinese tightening to cool an overheating economy and rampant real estate speculation, plus a weakening recovery in the US… the picture is not pretty.

In the US leading economic indicators have started turning over. The Economic Cycle Research Institute’s (ECRI) Weekly Leading Index has gone negative for the first time in over a year, falling to 123.2 from 124 the week before – the lowest level since July 2009. The ECRI WLI has historically been a good predictor of US economic activity, so its downturn is pointing toward a significant slowing in economic growth in the coming months. The Conference Board’s LEI for the US peaked in March.

China has taken steps to cool growth. China’s LEI (leading economic index) peaked last fall, Chinese PMIs are weakening and property market activity has been declining in response to the authorities’ measures to curb speculation. The worry is how much the world’s growth engine will now slow down; so far the economy remains very resilient (exports jumped 48.5% in May). However, the Shanghai Composite index is off nearly 30%, indicating weaker global growth prospects.

May saw the largest slump in commodity prices since Lehman’s collapse, pointing to potentially disappointing global economic growth. The Journal of Commerce Industrial Price Commodity Smoothed Price Index plunged 57% last month, the most since October 2008. Copper price broke down to a new 7-month low, before a bounce this week.

For now the global business cycle expansion appears intact but growth is starting to soften. A mid-cycle slowdown is not so unusual; however, it’s not immediately clear whether we should expect a normal moderation or indeed a double dip recession.

According to the yield curve a recession is not likely. Having correctly called past recessions when it inverted (short rates higher than long rates), the yield curve presently sees the risk of a recession in the next 12 months or so as near zero.

Buy on dips? Maybe not this time …

So, has the recent panic in the financial markets been overdone? The global economy and financial system are still fragile and vulnerable to further shocks, and confidence is fast evaporating. This is no time for complacency – things could get very ugly very fast.

On top of everything else, policy shock (including US financial regulatory reform outcome) is an additional risk investors have to consider. As is often the case, the authorities have been adding to the uncertainty by increasingly erratic moves (chaotic ECB actions, Germany’s ban of naked short selling of some financial stocks and eurozone sovereign bonds and CDS – likely to be further extended, etc). Such actions are counterproductive; they only heighten volatility, increasing the cost of capital and reducing liquidity.

May proved catastrophic for most assets, including equities, commodities (except gold), the euro. The winners have been the US dollar and Treasuries, reflecting a flight to safety as well as a symptom of a deflationary trend. (Money supply is falling at a pace not seen since the early 1930s!)

Markets went into June very oversold, so the relief rally currently underway was expected, and indeed could last a little longer. However it is unlikely to be more than a short term bounce. The S&P has now closed below its 200 day moving average for 16 consecutive sessions – a clear sign of trend change. Although we can’t yet be 100% certain that this is indeed something far more worrisome than a standard correction, there are signs that the trend has turned negative. Until there is more clarity it may be wise not to buy this market – you will likely be able to pick up most assets at much lower valuations late in the year.

It is true that the market has already priced in plenty of bad news – assuming the global recovery remains intact and there is no contagion from Europe; however, that scenario is increasingly looking too optimistic. Considered there is still a great deal of complacency, the bulls could be in for a nasty shock in the coming weeks and months.

Credit crunch is back!

Furthermore, there is good reason to believe this sell-off is different from the previous ones we have seen since March 2009 – the action in the credit markets. We have not witnessed significant deterioration and widening of credit spreads since the start of the rally – until several weeks ago. This is a fundamental change and a sign that the credit crisis is returning.

Credit is the early warning sign; equities lag deterioration in credit conditions. Decline in commodity and equity prices, and ultimately in economic growth, are a result of weakness in the credit markets. It would be foolish to overlook that the current correction has indeed a differentiating characteristics to it; do pay attention to the funding markets.

The European sovereign debt crisis is not going anywhere, and global credit conditions have been worsening. Cost of credit is rising and credit availability declining, which is affecting the funding needs of corporations worldwide. The economic fallout is only just starting to become apparent.

And it’s not only Europe. Higher cost of capital is also noticeable in the US and emerging markets where corporate debt spreads have been rising and debt issuance slowing. Funding markets are seizing up and capital is becoming more expensive, a consequence of which will be a squeeze in profits and slowdown in global growth.

Credit clearly continues to point to further stress ahead. Some disturbing signs that we may be witnessing the beginning of credit crisis 2.0:

Widening eurozone government bond spreads: yield spreads between German bunds and Club Med bonds have resumed their widening trend in recent weeks and in some cases became wider than before Europe’s mega bailout package was announced (although they tightened somewhat this week). And it’s not just the PIGS’s creditworthiness that has been deteriorating; we have seen huge spikes in CDS spreads on Eastern European sovereign debt and even that of France, Austria, UK and Germany over the last month.

European bank CDS have surged, indicating rising stress in the banking system, loss of confidence and growing risk aversion. It means sharply higher borrowing costs for banks. (European banks have raised less from the capital markets in the past six weeks than in any year since 1995.) Some smaller banks have been reported to be completely shut out of the credit markets. Even more troubling is that some of the world’s largest banks in Spain, Germany and France are now becoming infected. The Markit iTraxx Financial Index of CDS on 25 European banks and insurers soared to the highest level since March 2009 (before improving somewhat this week).

The LIBOR-OIS spread has widened significantly in recent weeks (now standing at 32.4bps). Equally, the TED spread has been deteriorating and is now at 47, up more than 300% in the last three months.

LIBOR-OIS and TED reflect the health of (and perceived credit risk in) the interbank lending markets. They are gauges of financial strength or weakness of banks. A rising spread shows that banks are unsure of the creditworthiness of other banks, hence charging higher interest rates to compensate for greater risk. Due to the European debt crisis counterparty risk is increasing and banks are reluctant to lend to each other once again.

Eurozone banks have been parking record sums in the European Central Bank’s deposit facility. Use of the facility, which pays an interest rate of just 0.25%, reached a new high of 364.6 billion euros (higher level than after the Lehman collapse) – a further sign that banks don’t trust each other’s creditworthiness, opting to instead deposit funds with the ECB.

The uncertainty is also rocking the corporate debt markets. May was the worst month for corporate bond sales for over a decade. Issuance of high-yield company debt nearly halted amid new signs that Europe’s sovereign debt crisis may be spreading; investment grade companies are also finding it more difficult to issue bonds. Both High Yield and Investment Grade spreads have soared in recent weeks.

There has also been substantial deterioration in the US Commercial Paper market (short-term IOUs), which contracted to its lowest level since 1999. Debt outstanding dropped, after six straight weeks of decline, to the lowest level on record as companies pared back on tapping short-term funding.

The European contagion impact and lack of liquidity is being felt in the emerging markets as well. New bond issuance of Brazilian companies halted for a sixth straight week, the longest stretch in 14 months, as Europe’s debt crisis drove up borrowing costs and caused a surge in volatility.

This worrying credit contraction is eerily reminiscent of the situation in summer 2007. Investors are fleeing all but the safest government securities. Poor liquidity and vanishing risk tolerance could see consumers contract, businesses stop hiring and investing and economic activity coming to a halt.

The prospects aren’t so good. A recent ECB forecast (Financial Stability Review, May 2010) that eurozone’s financial institutions may have to write off 195 billion euros of bad debts by 2011 – on top of the 238 billion already accounted for – confirmed fears about the fragility of the financial system.

Deflation and double-dip recession?

Meanwhile, the economic picture in Europe is not encouraging.

On the positive side, European core has been surprising with strong economic data; German manufacturing and exports are booming – exports to non-euro area have now surpassed the pre-Lehman bankruptcy peak (a weaker euro will only supercharge this growth), Germany’s PMIs are at a four year high; IFO Expectations Index is at its highest level since mid 2007.

On the other hand, Greece is insolvent and will unlikely avoid debt restructuring/default, which poses a massive risk for the European banking system. (Could Spain and Portugal also turn out to be insolvent in the end?) The hope is that Europe has bought sufficient time to stabilize the rest of the eurozone before a Greek debt restructuring.

The question is whether the European sovereign debt crisis could bring down Europe’s banking system, causing a collapse in confidence and economic activity similar to the fallout of Lehman in September 2008. It’s too early to tell, but a bank run (and a capital strike against eurozone investments) is looking increasingly more plausible.

(Of course European banks are already in a precarious shape, having made much less progress on writedowns and rebuilding of equity than US banks. They will also have to refinance some 800 billion euros in long-term debt by the end of 2012, and bank borrowing has already suffered a major blow because of sovereign risks – see notes above on deterioration in the credit markets.)

It’s not just the ultimate value of their government bond holdings the banks have to worry about. The deficit reduction and austerity programs much of Europe is embarking on are a step in the right direction but will inevitably kill consumption, investment and growth in the short to medium term. A long and painful deflation and severe recession in the periphery would appear unavoidable. (Defaults down the road are still a likely scenario.)

The fiscal retrenchment under way will see incomes in a number of eurozone countries beginning to fall in nominal terms; this will undermine the ability of households and businesses to service their debts, leading to a surge in private sector loan losses at European banks. Credit growth will also further contract as banks – already burdened with the until recently thought safe government bond holdings – will become even more reluctant to lend to riskier private sector borrowers.

Lack of credit will further reduce investment, job creation and economic growth. Slower growth and lower tax receipts will make it even more difficult for the periphery to get their debts under control. And, slower economic growth will create further problems for the banks, causing higher loan losses as highly indebted eurozone households and companies default on their loans. A vicious feedback loop.

A double dip recession in parts of the eurozone should, on itself, not have a disastrous impact on US and Asian economies, although some industries are companies will be more heavily exposed to diminishing European revenues (Europe is China’s largest export market). However, a potential collapse of the European banking system would undoubtedly have catastrophic consequences for the global financial markets, plunging the world back into recession.

And this time policy makers and central bankers would have little ammunition left to support the economy; interest rates are already at or near zero and there is (for now) little appetite for several more trillions worth of stimuli. That might change, of course, after a severe deflationary period, financial collapse, recession/depression; the Fed, ECB and other central banks and governments would then undoubtedly embark on quantitative easing and stimuli on a never before seen scale.

Deflation followed by hyperinflation, anyone?

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After months of optimism and growing complacency last week brought a sudden reversal of market sentiment. Optimism was replaced by worry and fear. Confidence was erased, despite a 110 billion euro EU/IMF bailout package for Greece and good US economic data; fear of a sovereign debt meltdown in Europe contributed to Tuesday’s and Wednesday’s sell-off, culminating in Thursday’s bloodbath. The Dow plunged nearly 1,000 points – the largest intraday decline on record – only to recover much of the loss minutes later. Even so, equities suffered their worst session since February 2009, with all major US indices ending the day down by more than 3%.

Escalating concerns of spreading European sovereign debt crisis, aided by images of murderous riots in Greece (casting further doubt of Greece’s ability to implement proposed austerity measures), provided the catalyst for the panic sell-off. Although some believe a trading error or technical glitch may have helped on the downside, the fact is the market was already very weak before the mid-afternoon plunge. The sell-off was, it appears, driven by good old fear.

More selling on Friday – despite better than expected US nonfarm payrolls report – reinforced the growing sense of panic. Both the Dow and the S&P 500 posted the largest weekly losses since March 2009 (DJIA fell by 5.7%, S&P was down 6.4% and the Nasdaq 8%), erasing all gains for the year. As fear spiked, so did the VIX (Chicago Board Options Exchange Volatility Index); it jumped by 86% – the largest weekly increase ever in its 20 year history. In a flight from risky assets the yen, dollar and gold were the best performers.

The EU/IMF providing just a short-term patch for Greece and no solution for other peripherals, financial markets remained unimpressed. Spreads in European sovereigns continued to blow out; the euro sliding further. There have also been increased concerns about European banks, which (as of end of 2009) hold claims of $193 billion on Greece and more than $1 trillion on Portugal, Ireland and Spain. Libor (the interbank lending rate) rose sharply as banks became increasingly suspicious of each other’s exposure to European peripheral sovereign debt.

The slide in the euro, soaring bond yields and global markets’ reaction to the crisis finally led eurozone governments to lay out a set of measures to safeguard the financial stability of the euro area. Last weekend they vaguely committed to additional fiscal consolidation and reform of the Stability and Growth Pact to ensure fiscal sustainability in the region.

As of Monday morning European leaders agreed on providing a massive rescue package of 750 billion euros ($960 billion) to eurozone countries in an effort to stop the sovereign debt crisis and contagion. Eurozone governments pledged 440 billion euros in new loans and guarantees and 60 billion under an existing lending program, with an additional 250 billion to come from the IMF.

The most dramatic intervention came with the announcement that the ECB (European Central Bank) would buy euro area public and private debt. The dollar swap line with the Fed has also been reactivated.

Yesterday’s rescue package averted an immediate crisis and will likely buy Europe some time to allow real fiscal adjustments to take place. However, while it helps eurozone sovereigns with near term financing, it does not fix the longer term debt and solvency problems.

Ultimately, Greece’s problem is not just one of liquidity but also solvency, so the country will still likely have to resort to debt restructuring (which has now been postponed). Without the option of currency devaluation, Greece must go through severe debt deflation. Incomes and tax revenues will plunge. The vicious circle of falling nominal GDP and rising debt/GDP ratio can only be stopped when growth resumes – which will be difficult without devaluation. Solvency risks will not go away anytime soon.

The euro currency downtrend will most likely continue. We may not be far away from a point when the ECB starts printing and effectively monetizing eurozone debt. Concerns of longer term viability of the single currency will also stay as peripheral economies sink deeper into debt deflation.

European periphery facing severe austerity programs and prolonged recessions will not only kill EU’s growth for the foreseeable future but also impact global demand that will go down just as the cyclical recovery is starting to face headwinds.

Where next for the markets?

Peripheral spreads have rallied spectacularly, retracing 50-75% of their widening since the end of March within just a few hours. However, this extreme narrowing is unlikely to be sustained unless the ECB continues buying peripheral debt. European, US and global equity markets also responded positively with a huge rally yesterday.

Last week’s Greek debt fallout provided a perfect trigger for corrective action – we were certainly due for one after the steep rally off the March 2009 lows. Bullish sentiment had reached levels consistent with short term tops (Investors Intelligence survey of investment advisers – a measure of the crowd’s sentiment – reported last Wednesday that 56% of advisers were bullish – the highest level since the 2007 market peak); equities and commodities were overbought. The amount of cash as a percentage of total assets at equity mutual funds was at a record low. Insider sales were at extremely high levels compared to insider buying.

At the moment it’s premature to say whether the sell-off is over; we could be seeing a relief rally, the correction could reassert itself and last for a few weeks. However, given the strong momentum from the March 2009 lows, decent valuations and good upside breadth the cyclical bull market certainly appears to be intact. The markets are bound to remain volatile for a while though.

The following chart shows the spike and subsequent decline in the VIX – also known as Wall Street’s ‘fear index’. A few weeks ago it was at 18 month lows, indicating high investor confidence (and complacency). As we’ve moved from optimism to fear and dread last week volatility rocketed, only to fall back after Monday’s eurozone bailout news.

(The VIX is a measure of the implied volatility of S&P 500 Index options. A low value indicates expected stability in the markets; a high value means expected turmoil. So the VIX tends to exhibit a strong negative correlation with equity prices.)

Another sentiment indicator, the equity put/call ratio, was also very stretched by the end of April, indicating extreme bullish sentiment. As optimism turned into fear the put/call ratio spiked up.

A look at April breadth measures also signaled an imminent correction as over 90% of S&P500 stocks traded above 50 day moving average. We dropped to oversold territory last week, before bouncing back somewhat.

As risk aversion grows US equities could benefit from a flight of capital from Europe; though it will more likely continue to flow into bonds. Importantly, the US economy is improving on all metrics.

We are now seeing a starting recovery in the labor market, based on the payrolls numbers as well as Household Survey employment data. Last Friday’s US nonfarm payrolls surprised to the upside with 290,000 jobs added in April – much better than the anticipated 180,000, with the March number revised upward to 230,000. However, the unemployment rate increased to 9.9% from 9.7% due to a surge in the workforce. (Also, census hiring added 66,000 jobs to the April number.)

There is no doubt about the strong recovery in US manufacturing, as witnessed by ISM data (at 60.4% as of April). The manufacturing sector expanded for the eighth consecutive month to its highest level since July 2004. The pace of new orders was very strong and employment within the sector continued to grow.

Consumer spending has been rising (albeit at the expense of the savings rate). Retail sales rose above expectations in April, for the fifth time in the last six months.

Despite positive US data investors remain skeptical about the health of the economic expansion. At present the consensus is for subdued economic growth; that might end up proving to be too conservative.

Short term interest rates are at their multi-decade lows. Even if rates were to start rising faster than expected, the environment will stay very stimulative for a long time. Low interest rates provide a subsidy to income, profits and economic growth.

Whereas liquidity has been the main driver of the stock market rally until now, the next phase will likely be spurred by growth and profits, with performance depending on expanding economy. Low rates, strengthening business activity and strong balance sheet conditions will drive earnings growth. (Earnings have been very positive, beating expectations in most cases. Expectations of S&P 500 operating earnings are in the region of $80-84 by the end of 2010.)

If economic growth is decent and rates stay low, profits will likely keep surprising on the upside. Of course better economic growth, employment growth and improving corporate profitability will eventually see a rise in interest rates. That alone is, however, not automatically negative for stocks. It is generally only when interest rates start to exceed the nominal GDP growth that the economy slows down. The yield curve also has to become inverted for a cyclical equity bear market to be triggered. Historically, cyclical bear markets were triggered when the yield curve became inverted at a level that was higher than the nominal GDP growth. We are nowhere near that point.

The cyclical bull market has further to go, although the pace of price gains is likely to be much slower, given the steep rally off the March 2009 lows. Most retail investors have not yet moved into equities and are sitting on the sidelines. Yet there is little reason to believe that they will not do so again once confidence in the rally becomes more widespread. Optimism should increase as evidence accumulates on the strength and durability of the economic expansion.

US fundamentals look good for now: leading indicators of growth remain strong, rates are extremely low, earnings are beating expectations, valuations are reasonable.

Equities are relatively cheap on 1-2 year forward valuations (PE of 14 and 12, respectively). Global equities valuations are also attractive at 12M forward consensus earnings multiple of 13. Emerging markets trade on a 12M forward P/E of 12, although they have, over the last two decades, grown earnings at an annual rate of 22% vs. 12% in developed markets, as well as having lower leverage and higher economic growth. Equities are also cheap relative to bonds (as per dividend yield/bond yield ratio).

Retail investors have been net sellers of equities since March 2009. The total allocation to equities by the US household sector is well below long term average. Global bond funds posted inflows of $83.5 billion this year, equity funds saw inflows of only $7 billion. Since the trough of March 2009 US equity funds inflows came to $40 billion compared to bond funds inflows of $360 billion. Retail investors have so far not participated in the rally – retail equity funds saw net outflows of $82 billion since March 2009 (though in March 2010 retail have been modest net buyers). Institutional equity funds have seen modest net inflows since March 2009. (Data from EPFR Global and Credit Suisse.)

Central banks will likely continue to flood the system with liquidity whenever deemed necessary, and the Fed will keep short term rates in real terms (inflation adjusted) below zero for a very long period of time – all of which is positive for equities. And, as noted, there is plenty of cash available from investors who have missed the rally and are still sitting on the sidelines.

I believe the cyclical bull market (i.e. rally within the secular bear that started in 2000) will go on for a while, so any 10-20% corrections may be seen as a buying opportunity for select equities.

There are of course a number of medium to long term concerns.

The situation in parts of the eurozone will remain precarious. Austerity measures will plunge the periphery into a deep and prolonged recession, while bailouts will come at the expense of the productive European economies, all dragging down demand. Europe will buy less US goods, and with the euro likely close to or at parity to the dollar US companies won’t be able to compete with European exporters. This could well slow down US growth by late 2010 and 2011. (Tax hikes will also kick in next year.)

China is tightening in an attempt to slow down its economy, amidst concerns of overheating and housing bubbles. (The Shanghai Composite Index has broken below its key 200-day moving average – a possible precursor of what’s to come in other markets?) Brazil and India (and much of the rest of the developing world) are raising interest rates to fight inflation.

Concerns also remain about US regulatory changes, including financial reform.

The US housing market is a weak spot that needs monitoring. Although prices are stabilizing, the overall picture remains worrying, in particular due to the massive amount of unsold overhang remaining in the system. On the positive side, house price to income ratio is now close to a 40-year low and yields on low-end properties are, according to Credit Suisse research, over 8% – the highest on record relative to 30-year mortgage rate.

And there are still some $6.5 trillion of excess leverage in the developed economies, which will end up reducing growth. Government bond funding will also become more of a problem in the next few years, and not just in Europe. Economies won’t be able to simply grow their way out of fiscal indebtedness. In order to stabilize government debt to GDP fiscal policy will have to be tightened significantly (in the US, UK, Japan, much of the eurozone), which will be extremely challenging both politically and economically. We are still heading toward sovereign defaults a few years from now.

If we are lucky, we may have another 12-18 months before things start getting ugly again.

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