Q & A with Prieur du Plessis on global economy, markets
I have recently been interviewed by the South African media on a number of issues regarding the global economy and markets. An edited version, in Q & A format, is provided below.
The rout in global financial markets is continuing, characterized by extreme swings of up to 5% in some markets. What is the reason behind the extreme volatilities in the markets?
PdP: There are a couple of reasons but at this stage the major factor seems to be the possibility of Greece defaulting on its debt on its own terms. If that happens, the entire Eurozone financial system would be at risk as some major banks’ balance sheets will come under huge pressure. This in turn is likely to trigger a liquidity crisis that will certainly rub off on the rest of the world. In addition, the European Union would come under scrutiny, as would the existence of the euro.
If Greece defaults, can the world afford it? Is there a way out?
PdP: The European Union and the rest of the world cannot afford another liquidity crisis of the same magnitude as in 2008/09. I am of the opinion that Greece will be allowed an orderly default where some of its debt will effectively be written off by other governments, and that vulnerable banks will be recapitalized by the European Financial Stability Facility (EFSF) that is financed by members of the Eurozone to combat the sovereign debt crisis. The debt crisis and Greece deadlock have already dented business confidence in the Eurozone and resulted in the contraction in both the manufacturing and services sectors of the economy.
What other factors besides the sovereign debt crisis contribute to the extreme volatilities in the markets?
PdP: Well, it is in fact a combination of factors. When the debt crisis started in the Eurozone’s Mediterranean countries and Ireland last year the big concern was always whether there would be contagion to other Eurozone countries and the rest of the world. Uncertainty was exacerbated by the uprisings in the MENA countries that started in earnest in January, resulting in a strong rise in the oil price due to supply concerns. Then in March Japan’s terrible twin disasters struck and had an immediate impact on China as global economic growth locomotive. Consumer and business confidence is under heavy pressure in the U.S. as employment has stagnated with austerity measures implemented in the government sector.
Although the rebuilding of Japan is on schedule, the strong yen is hurting exports, while China’s normal seasonal strength in its manufacturing sector is below par. Growth in global manufacturing halted for all intents and purposes and a currency war between the majors developed with the Swiss and Japanese at the forefront to stave off further appreciation of their already overvalued currencies, resulting in the Swiss pegging their currency against the euro at lower levels.
What will bring the extreme volatilities down? What will calm the markets?
PdP: Good question! The markets obviously want to see central bank action that will ensure growth and, most importantly, restore confidence. Our studies have indicated that the most important factor in restoring order in financial markets is value. In fact, very rich market valuations and weakening economic indicators had resulted in increased volatility long before the 2008/09 market crash started. This behaviour can also be traced to other stock market crashes over the past 40 years. Volatility subsided only when market valuations returned to levels where major investment houses saw good value again. That preceded better economic fundamentals.
And the current situation … Are we there yet?
PdP: I certainly think we are approaching those levels where financial institutions start bargain-hunting. From a value point of view as measured by the Shiller PE10 ratio the S&P 500 is at its least expensive levels since September 1992 (excluding the 2008/2007 liquidity crisis) at a PE10 of 19.5. Although it is still at a premium to its long-term average of 16.4 since 1881, the PE you pay per unit of volatility is in the same range as that paid for at the bottom of the bear markets of 1987, 1990, 2002/2003 and 2008/2009.
Is this the bottom in stock markets?
PdP: The major sell-off in gold recently caught my attention. The top of anxiety in financial markets in 2008 coincided with a major sell-off in gold. I think there is a more-than-equal chance that we are hovering around the bottom in risk asset markets. However, I do believe there is a real risk of another deep sell-off in the S&P 500 that could shave off another 15%, especially if another unnamed black swan appears. That to me would be the ultimate bargain I am waiting for.
What asset classes do you favor?
PdP: Our analysis indicates that all markets correctly reflect the height of anxiety. At this point in time I am going long on emerging-market equities and bonds, long on silver and platinum, long on emerging-market currencies and adding to my euro position.
What asset classes do you favor the least?
PdP: I have to say mature-market bonds, especially the long end. I think the Fed’s “Operation Twist” whereby the Fed will sell shorter-term Treasury holdings and buy long-term debt and mortgage-backed securities to support mortgage refinancing activity, will probably keep long bond prices higher, so I will refrain from shorting them outright. But it is a bubble developing.
And the favorites and least favored in your home country, South Africa?
PdP: The fall of the rand in line with other emerging-market currencies has cushioned the local market. R100 invested in the FTSE/JSE All Share Index at the end of last year would be worth R92.53. In contrast, U.S.$100 invested in the same index at the same time would only be worth U.S.$76.27! Secondary rand hedges such as dual-listed foreign companies and primary rand hedges such as mining and resources stocks benefited substantially. At this stage I am taking an interest in domestic financial and industrial companies and considering going long of the rand.
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