Global shares have hit another rough patch recently. This started in mid-September, spread to Australian shares in mid-October and to Asian shares this month.
The weakness accelerated after the US election. And consistent with the classic risk on/risk off pattern of the last few years the fall in shares has been associated with lower commodity prices and a rally in sovereign bonds. So far, the top to bottom falls in share markets have been mild at around 5-6%, except for the US, which had an 8% fall. And there has been a partial bounce back over the past few days.
As usual whenever shares have hit a rough patch over the past few years the usual perma bears come out in force, warning of a crash ahead and “double dip” back into global recession. But how big are the risks? Is this just another correction or the start of something more serious?
What’s driving the rough patch?
But to start with, what’s driving the recent rough patch? Several factors are involved:
- Firstly, after a 15% rally in global, Asian and Australian shares coming out of the low in early June, shares were vulnerable to a correction.
- Secondly, while the ECB has done well to backstop Spain with its promise to buy its bonds under certain conditions, Spain’s failure so far to apply for assistance, continuing uncertainty about Greece, renewed fears regarding France (we heard this one late last year and early this year, but why not give it a whirl again!) and soft economic data across the euro zone has seen uncertainty continue regarding Europe.
- Thirdly, September quarter earnings reports were generally soft, particularly on the revenue front in the US.
- Fourthly, after the US election US shares priced out the possibility of a smooth solution to the US ‘fiscal cliff’ and started to fret that it would trigger a recession next year. Soft data on the back of hurricane Sandy hasn’t helped.
Renewed tensions in the Middle East – this time between Israel and Gaza – haven’t helped either. This is likely to be just another regular flare up of the Israeli/Palestinian conflict, but without Saudi Arabia and other major producers deciding to punish the US for supporting Israel by cutting oil supplies – which seems unlikely – the impact on oil prices is likely to be trivial.
To this list may be added investors cashing up ahead of the end of the world on December 21 when the 5125 year-long cycle Mayan calendar ends. But then again, what’s the point of cashing up ahead of the end of the world? Once it ends, cash will be no more valuable than shares.
More seriously, the whole obsession with the world ending on December 21 seems to be based on a complete misrepresentation of Mayan culture and their calendar. And if the Mayans are not enough, there are claims that US psychic and prophet Edgar Cayce prophesied a share market crash on December 18, 2012 – obviously trying to get in ahead of the Mayans! Taking this one seriously, I searched through Edgar Cayce’s prophecies (yes – I have his books) only to struggle in vain when it came to any references to 2012.
What’s the risk of recession in 2013?
But back to reality, for shares to continue to plunge taking us into a new bear market, global growth really needs to head back towards or into recession next year.
Source: Congressional Budget Office
So the key issue is how realistic is this? It’s certainly a risk:
- Europe is still very weak, with peripheral countries likely to remain in recession next year;
- The US economy will almost certainly plunge into recession if the legislated tax hikes and spending cuts that kick in from January amounting to 4.3% of GDP and known as the “fiscal cliff” are not reduced to something more manageable – say around 1.5% of GDP. The US economy is running at 2% growth, so a 4.3% of GDP fiscal contraction would probably knock it into recession;
- Global business conditions indicators have stabilised but are yet to really strengthen – see the next chart; and
- A return to global weakness next year would be consistent with the three to five-year business cycle, given that the last severe downturn was in 2008-09.
Source: Bloomberg, AMP Capital
However, we don’t think that a return to global recession or even a sharp further slowdown is probable next year.
While it’s hard to see Europe strengthening much next year it’s hard to see it getting a lot worse either. Thanks to the ECB, Europe finally seems to have a decent program to bring bond yields under control in troubled countries.
While Spain has yet to apply for assistance the threat that the ECB will aggressively buy its bonds if it does has led to a distinct calming in bond markets across Europe. This plus the ECB’s provision of cheap funding to banks seems to have completely headed off a re-run of the GFC and has left Europe with a mild recession.
However, the ECB is likely to provide more monetary stimulus if growth doesn’t pick up and the euro zone seems to be relaxing the pace of fiscal austerity, granting Greece another two years to meet its targets and indicating that Spain could be granted assistance without having to undertake further austerity.
While the US “fiscal cliff” is unlikely to be resolved until December, the most likely outcome is that a compromise will be reached. The Republicans won’t want to be blamed for triggering a recession and President Obama won’t want his legacy to be remembered for recession, trench warfare with the Republicans and inaction in terms of a long term budget solution.
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