Anxiety pervades skittish markets

by | Jun 2, 2012 | Business

A sharemarket dabbler would have done well this year to adhere to the old adage “sell in May and go away”, provided they sold at the beginning of the month.

Like clockwork, there was the traditional sharemarket rally through Christmas and the New Year. Then came May, a shocker, down 7.5 per cent, erasing the year’s gains and $100 billion in market value.

And now there is fear. The bond market, usually a harbinger of what is in store for equities, is warning things will turn ugly.

In a flight to safety that eclipsed even the depths of the financial crisis, government debt yields touched 60-year lows this week: three-year bonds fetched 2.09 per cent – incidentally, a full 4 per cent below the banks’ three-year fixed rates.

Credit markets are forewarning a good chance the Reserve Bank will lop a full 50 points cut from its official 3.75 per cent cash rate when its board meets next week; and at least another 1 per cent down the track, to boot.

For the latter to occur, as Goldman Sachs noted this week, “China will have to blow up, Europe disintegrates and the US double-dips.

“Then we’d also be gone – Aussie house prices down 20 per cent.”

This was unlikely, the broker said, an “Armageddon scenario”, but nevertheless an outcome borne out by this week’s market action around the world.

The vital question is: what to do about this unpleasant little Armageddon scenario? In Washington and Brussels, the policy makers are hapless. They have fired their shots. Three years of zero interest rates and incessant money printing.

Wall Street is baying for the Federal Reserve to crank up the printing presses again and deliver QE3 (a third quantitative easing program where the US buys its own debt).

They don’t care for David Einhorn much on Wall Street. The 43-year-old hedge fund manager hit the spotlights in 2008 when he cleaned up by short-selling Lehman Brothers.

Einhorn is a well-known critic of the investment banks. His thesis is they pay out 50 per cent of their revenues to staff and so have an incentive to take unacceptable risks, operating with high leverage to tart up their returns.

Since they are too big to fail, though, that risk is effectively carried by the system. It is risk for everyone but rewards for a few.

Einhorn didn’t ingratiate himself with the Fed much either when he penned a long comment piece on The Huffington Post a couple of months ago lambasting its easy money routine.

“A jelly doughnut is a yummy mid-afternoon energy boost.

”Two jelly doughnuts are an indulgent breakfast. Three jelly doughnuts may induce a tummy ache.

”Six jelly doughnuts – that’s an eating disorder.

”My point is that you can have too much of a good thing and overdoses are destructive. Chairman [Ben] Bernanke is presently force-feeding us what seems like the 36th jelly doughnut of easy money and wondering why it isn’t giving us energy or making us feel better.

”Instead of a robust recovery, the economy continues to be sluggish. Last year, when asked why his measures weren’t working, he suggested it was ‘bad luck’.”

Things have deteriorated further on the economic front since Einhorn’s jelly doughnut dissertation.

“Another blob of jelly that we are still working to digest is the Fed’s promise to keep rates at zero for a long time. Chairman Bernanke hopes this will encourage borrowing and investment, but it may have the opposite effect because it undermines any sense of urgency. By setting the time value of money to zero, the Fed devalues time.”

Although things look bleak, and will likely get worse before they get better, there are still a few things going for the sharemarket.

One is valuation. It is 10 per cent cheaper than it was just a few weeks ago. And it has a yield, in contrast to bonds, where the 10-year Commonwealth variety is yielding just 2.84 per cent.

This is not good news for the endangered species of the self-funded retiree and the saver who has to eke out their living on such a paltry return.

Though we stick to our prediction of inflation and higher rates down the track (even as this seems more improbable now than it did when we last espoused our bond bubble thesis).

However, looking on the bright side, it is simply not natural to the market psyche, or to the human psyche for that matter, to stay down for too long. On the charts, the past five years already resembles the Great Crash and the ensuing slow recovery.

Recovery, however, is not plausible before Europe fractures. And when it does arrive it will be spluttering and snail-like as the world continues to deleverage from the greatest boom in history and the subsequent jelly doughnut bacchanalia.

In the meantime, sugar fixes are failing. As they officially strive for tighter fiscal union in Europe, unofficially they contemplate their break-up options.

So far, though the union remains intact, the people have prevailed over the banks. Successive European governments have fallen victim to their own austerity measures.

Meanwhile, the banks are still leveraged 26 to one and the region’s banking system is $46 trillion in size. That’s four times the size of the US and three times Europe’s gross domestic product – against an ECB balance sheet of just $4 trillion.

As investors took flight into US treasuries this week, and Australian bonds as well, yields in Spain and Italy shot the other way. The failure of policy has only deepened the despair.

Something has to give. And another round of jelly doughnuts won’t do the trick for too long, if at all.


Michael West

Michael West

Michael West established to focus on journalism of high public interest, particularly the rising power of corporations over democracy. Formerly a journalist and editor at Fairfax newspapers and a columnist at News Corp, West was appointed Adjunct Associate Professor at the University of Sydney’s School of Social and Political Sciences. You can follow Michael on Twitter @MichaelWestBiz.

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