Global Stock Markets off to Strong Start in 2012 Led by Emerging Markets

So far this year global stock markets have risen at a rapid pace; extending the rally begun in the fourth quarter of 2011.  Since January 1, the S&P 500 gained 4.5%, a starting year rally not seen since 1987. Over the same time period, the iShares MSCI Emerging Markets Index Fund (EEM) gained 9.1%, the fastest rise since 2001.

Articles in the Financial Times and Bloomberg have noted a pattern in this rally. The biggest decliners last year have led the charge this year. Year to date the EEM, which lost 21.1% in 2011, has gained twice as much as the S&P 500. On a sector basis within the S&P 500, financials, industrials, and materials have been leading the recent rally. These same sectors have greater exposure to emerging markets and were among the worst performers last year. Utilities, health care, and consumer staples had been the best performing sectors in 2011 but have been among the worst performing sectors in 2012.

Economists attribute the surge to a number of reasons:  in the U.S., positive economic data continues to flow, manufacturing is growing, jobless claims are falling, and the unemployment rate is ticking down. Corporate profits remain high and Fed policy continues to be accommodating. Earnings season has begun with 60% of reporting companies beating expectations. Many global central banks are lowering rates in order to promote growth after two years of raising rates. As mentioned in Marietta’s blog Promising News from China, recent events in China indicate that economic stimulus and easing will likely come soon to this engine of global economic growth.

Three weeks do not make a year, but a continuation of current trends could result in 2012 being dramatically different from 2011.

China Watch Update

Over a year has passed since we posted a blog “International Stock Markets: Searching for Goldilocks” (5/12/2010) in which we commented on the rising inflation problem in China and the damage it was inflicting on the Chinese stock market. More recently, on March 22, we issued a blog “China Watch: Is Goldilocks Waking Up” in which we pointed out that continuing stock market underperformance was a consequence of increasing concern among investors that the government would go too far and inadvertently cripple economic growth. We drew 3 conclusions:

• Chinese stocks would continue to languish (at best) as long as inflation continued to rise and policy makers continued to impose additional restrictive measures.

• Eventually the government and the central bank would be successful in piloting a “soft landing,” i.e. they would slow the economy and usher in a period of healthy and sustainable growth with reduced and controlled inflation.

• The “soft landing”would spark a strong stock market rally.

Fear of inflation and possible asset bubbles continues to be the central focus of investors and the Chinese government. Since the start of 2010 the People’s Bank of China (PBOC) has hiked bank reserve requirements 12 times, and on 4 occasions it raised the base interest rate. Nevertheless, inflation has risen steadily and is now, at 5.5%, above the government’s 4% target.

The latest important development was an article “How China plans to Reinforce the Global Recovery” in The Financial Times (6/23/11) authored by Chinese Premier Wen Jiabao. After touting the considerable strengths of the Chinese economy and the government’s achievements in promoting social reforms, implementing massive infrastructure programs, and sponsoring scientific and technology initiatives, he made remarkably confident statements regarding inflation:

There is concern as to whether China can rein in inflation and sustain its rapid development. My answer is an emphatic yes…China has made capping price rises the priority of macroeconomic regulation and introduced a host of targeted policies. These have worked…We are confident price rises will be firmly under control this year.

Investors in Chinese stocks interpreted the Premier’s confidence as a signal that the period of restrictive credit policies was over and China was headed for the desired “soft landing.” Since June 20, the Shanghai Stock Exchange Composite Index (CSEX) has rallied 4.1%, but is still down -10.6% since April 15 and over 50% from its peak in October of 2007. If the government can convince investors that it is correct in its claim that inflation can be kept below 5% and GDP growth over 8% for the foreseeable future, then the Shanghai market recovery has only just begun. The market’s P/E valuation, at 11.6 times estimated profits, is the lowest since the global financial crisis in November of 2008 and, according to research analyst estimates compiled by Bloomberg (6/27/2011), Shanghai index profits are expected to soar 32% in the next 12 months.

Good Reading: Lords of Finance

Good reading: Lords of Finance: The Bankers Who Broke The World by Liaquat Ahamed (Penguin Press, 2009), 505 pp.

For investors tracking the ongoing efforts of governments and central banks to battle recessionary pressures and engineer a global economic recovery, we recommend strongly Ahamed’s informed and captivating Lords of Finance. The book focuses on the largely successful efforts of the central bankers of the U.S., England, France and Germany to restore economic and currency stability following the chaos of World War I and their subsequent policy mistakes that helped bring on the Great Depression. These bankers were men of sharply divergent backgrounds and personalities, and they were committed to the sometimes conflicting interests of their respective countries. Nevertheless, they managed at critical moments in the 1920s to coordinate policies, overcome the obstacles thrown in their path by the politicians, and weather one crisis after another. The glue that held them together was a near-religious faith in the gold standard, which they managed to restore after World War I and to maintain for a tumultuous decade. Ironically, the author argues that it was their slavish adherence to this inflexible gold standard that ultimately triggered the Depression and in the process tragically ruined their careers and reputations. For the author, who is no fan of the gold standard, the heroes of the book are John Maynard Keynes, the brilliant and controversial English critic of these central bankers, and Franklin Roosevelt, who rejected the insistent advice of his economic advisors and took the U.S. off the gold standard at the depths of the Depression in 1933.

Readers will enjoy and profit from Lords of Finance even if they are not sophisticated in economics or historians of the Great Depression. Ahamed, whose background includes a stint at the World Bank, patiently and expertly explains the formation of the Federal Reserve and its inner workings through the 1920s and 1930s. He also provides a clear explanation of the gold standard with its benefits and limitations, and places the economic and currency crises within a broader political and social historical context. Readers will also appreciate the ability of the author to paint personality portraits of the major protagonists. The book is a useful antidote to the currently fashionable thesis that seismic economic events, such as the Great Depression, are the consequence of largely impersonal and unavoidable political, social and demographic trends.

In a very instructive epilogue, Ahamed compares the Great Depression with the 2008-2009 global economic and financial crisis. Although he acknowledges the two events share many of the same characteristics, he concludes that the differences outweigh the similarities. His major point is that The Depression was the consequence of the misguided policies of politicians and central bankers; modern policy makers, enlightened by the errors of their predecessors, are now pursuing a contrary set of policies that will result in a more favorable conclusion.

The book deserves its accolade as the Financial Times and Goldman Sachs 2009 business book of the year.

China and Brazil Watch

In our January 4 Outlook, we contrasted the accelerating economic strength of China, India, and Brazil with the struggling U.S. and European recoveries. Fresh evidence of Chinese prosperity is the surprising surge in both exports and imports in data released overnight. Another indication may be found in today’s Financial Times in an article “China lenders eclipse U.S. rivals.” The article reveals that all 7 of the world’s top valued banks (ranked by bank share price to book value) are Chinese or Brazilian, and concludes the data “reflect growing [investor] confidence in emerging markets, particularly China and Brazil.” In 2000, 5 of the top 6 highest valued banks were American. To highlight the contrast among economies, another article on the same page of the Financial Times, “Lingering doubts over recovery keep European inventories low” reveals that European business executives continue to have very low confidence in their own economic future. To be sure, the latest The Economist poll of forecasters (1/9/2010) foresees an anemic 1.4% real GDP growth for Euro area in 2010.