While there are still lots of pundits talking stagflation and the like, the reality is that market action grows ever more deflationary, prompting CLSA’s Christopher Wood to put out a mid-week edition of his newsletter Greed & Fear.
In recent days the venerable Dow Theory has given a bear market signal according to some interpretations. While Wood is not about to bet the bank on the predictive powers of such a signal, it’s certainly worth noting, he says.
More worrying, in Wood’s view, is the way financial stocks are continuing to lead western equity markets down and the way US Treasury bond yields across the maturity range are plunging while interbank rates are again rising both in America and Europe.
Without going into detail, the message is clear:
The unwinding of structured finance is causing an accelerating global credit crunch which threatens not only US consumption but also the vigour of the current global economic cycle. Meanwhile, the risk of market-moving financial accidents is rising daily, as shown by Citicorp’s desperate sale on Tuesday of $7.5bn worth of equity units to the Abu Dhabi Investment Authority.
All this is why it is only a matter of time before the Fed cuts interest rates again and why there will be, sooner or later, co-ordinated interest rate cuts which will include the Bank of England and the ECB and maybe (horror of horrors) even Japan.
The longer that central banks, led by the Fed, fail to act on rate cuts the more vulnerable equities are in the near term, warns Wood. In this sense the next FOMC meeting on December 11 “looks a long way off”. Still the message for dedicated Asian equity investors remains clear. They need to be looking to remove all cyclical stocks from their portfolio and to own domestic demand and interest-rate sensitive shares; though in the latter case, not those shares with “feared exposure to structured excreta”.
At the same time, it is true that not all market action is flashing deflationary signals. The oil-led commodity complex remains remarkably robust while the US dollar remains weak. But in Wood’s view, commodities will decline sharply and the US dollar will rally sharply when it “finally dawns” on global equity investors that the global economy is vulnerable to a slowdown in US consumption. The reason it has not done so as yet, says Wood, is because “stock markets are much more stupid than bond markets”.
Meanwhile, as he noted earlier, “the supreme cyclical indicator may be shipping and on that point the Baltic Dry Index looks like it has begun to break down”. For investors in Asia, the message again is to “reduce cyclical exposure and to use any possible post-Fed rate cut rally to reduce further cyclical exposure”.
This is a much more important recommendation than the relative country bets within Asia because the reality is that all Asian markets have cyclical exposure, as has been only too clear in the starkly contrasting performance between cyclical stocks and domestic stocks in markets like Korea and Japan throughout 2007.
As for gold: Like other commodities, it is tactically vulnerable in a commodity correction. But still, Wood advises, rather than selling gold, buy more bullion on weakness. It is also the case that an oil-led commodity correction would be a fantastic buying opportunity for gold shares whose profit margins have been hammered by rising production costs in recent years. Remember, he says, that gold is a hedge against the “increasingly inevitable collapse of the US dollar paper standard” and is not a bet on the economic cycle. Indeed structured finance will prove to be the catalyst to accelerate the demise of the paper dollar standard, since it is the best reflection of the total lack of discipline in that system.