Clear and present danger to stocks from reality

Sentiment is fraying at the edges for stocks globally, and have imparted a momentary pause upon Gulf bourses.

Until the past week both international and regional stock markets had been growing in leaps and bounds. The hope is that improvements to underlying economic conditions have truly taken root. The fear is that what we are seeing is merely the reflation of a bubble, not dissimilar to the one which burst so spectacularly around five years ago.

The US Fed chairman’s latest utterances helped bring this conundrum to the forefront of market thinking and behaviour, particularly in terms of how prolonged will be the artificial support coming from quantitative easing (QE). Poor Chinese economic data and the pricking of Japan’s exaggeratedly distorted equity rally have also featured.

Investors within this region might take further pause themselves, to consider some of the pertinent detail.

They might listen to asset allocation specialists who have not only pored over the trends, but infused their analyses with ‘micro’ findings that drill deeper and therefore can supplement the basic ‘macro’(economic) statistics with which we’re all familiar.

Ricky Hussaini, chief investment office at Trading Portfolio, has laid out a strategic case based on that kind of approach, amassing a series of observations about the world economy, serving a local perspective.

Real recovery has been “tepid”, he told a conference in an absorbing address recently. While key central banks are putting everything into creating monetary stimulus to boost the business cycle, even so there are “structural headwinds” that will compromise its impact.

Interest rates

The fact that his explanation incorporated (a) a vivid illustration of what is wrong with the QE approach being followed by the Western authorities, and (b) how sukuk, which have captured the imagination of those seeking an alternative to conventional bonds, might fare in these circumstances grabbed my attention.

As to the QE issue, the Fed has grown its balance sheet enormously to absorb government stock, aiming to keep interest rates down across the yield curve, and thereby sustain consumers in their dominant role in propelling the economy.

Yet, as a graphic highlighted by Hussaini showed, the explosion of the assets it holds for these purposes is counteracted by the liabilities placed by the commercial banks back with the central bank, effectively all but completely negating the monetary impetus.

Moreover, a one per cent rise in interest rates, if growth and inflation were to take off, would lead to a scary eight per cent decline in the worth of the Fed’s portfolio of Treasuries and mortgage-backed securities, whose maturities have lengthened in a disturbing manner. It’s not only bond investors who could take fright if this massive experiment doesn’t work out. There is a horrendous debt overload still to be unwound.

Most opportunely, Hussaini endorsed the view that stocks were overheated, with a clear divergence to inflation expectations (not to mention growth prospects). With Mena indices back at 2008 highs, there is greed about, he remarked, and “memories are short”. Besides which, there is a detectible urgency in the search for income. Furthermore, the speed with which real estate is turning over in the Gulf again is an anecdotal pointer of the retracement of a well-worn and very bumpy road.

Investment strategy

Such insights should jolt the senses. Where does that leave the overexposed regional investor now? Among the mainstream ideas, Hussaini perceives US and emerging markets more likely to perform well than Europe, and Saudi and Qatari banks as undervalued. Alternatively, if purely short-term perspectives can be overcome, “clean-tech, renewable energy and food security are long-term trends which are increasingly gaining traction.”

These cautionary notes seemed very timely when delivered. As the markets themselves have appeared promptly to prove the point, with their music and dancing perhaps losing steam, it certainly seems like the moment to review investment strategy with particular care.