Major shake-out in global equity markets looms

JOHANNESBURG – A major shake-out in global equity markets is looming.

The big “R” will make landfall sooner than later and no, it is not President Cyril Ramaphosa or the rand. The next stage in the global business cycle is most probably a recession.

While some global economic indicators are still pointing to a modest expansion underscored by the services sector, evidence continues to point to diminishing economic growth globally.

Weak international trade flows as a result of US protectionism, the Sino/US trade war and Brexit worries have without doubt brought the risk of contraction phase forward.

While protection ring fenced the US economy to some extent, new evidence suggests that the countdown for a US recession has begun.

The US is past the cycle peak in the business cycle. Spare capacity in the US economy is rising faster than employment. Most analysts and economists focus on the inverse of the yield curve, where longer-term government bonds fall below short-term rates as a precursor to a recession. The ratio of spare capacity to employment in fact tends to lead the yield curve by between three and six months, while it peaks six to nine months before economic downturns.

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Worst of all is that the US is in a fix, no matter what the Federal Reserve or President Donald Trump do.

The US is still near full employment, the highest in 50 years.

With idle capacity increasing it means that business will be reluctant to expand. The vicious circle of a downswing/recession is about to begin, regardless of a truce in the Sino/US trade war. Capital goods orders are likely to come under pressure. Company profits come under pressure. Jobs will be lost. Value will be destroyed in equity markets and business and consumer confidence will come under pressure.

The eurozone finds itself in a similar situation. In the eurozone capacity is also rising faster than employment, while, according to the Federal Reserve Bank of St Louis, Germany fell into recession in the fourth quarter of last year.

Yield curves globally are likely to rise – not as a result of improved economic growth down the line, but due to shorter-term interest rates falling faster than long-term rates. It will be the confirmation of the next cyclical downturn. Quantitative easing will be the order of the day as central banks aggressively ease monetary policies.

A surge in business confidence similar to after Ramaphosa’s election in 2017 is in the offing for South Africa.

Ramaphosa’s commitment to clean government and reform agenda in coming weeks will determine whether the rand will claw back the losses against emerging market currencies since the middle of last year.

Confidence and growth in South Africa will be stymied by global growth stalling/recession, while an acceleration of the cyclical downturn will further put downward pressure on emerging market currencies and the rand against the US dollar.

Global 10-year government bond yields compared to the corresponding economies’ credit ratings are substantially lower than in November last year, indicating that bond markets are pricing in slower economic growth ahead of even a recession.

US stock markets are reflecting current consumer confidence, but are very vulnerable. Company profits will come under severe pressure, with spare capacity in the economy rising faster than employment. With near full employment it means that business will be reluctant to expand capacity and job losses will see consumer confidence plunging.

Using the Shiller PE10 metrics, valuation lows of December 2015 and March 2003 may be revisited with a downside on S&P 500 is 15percent, but may overshoot on the downside.

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The major divergence of developed market equities (MSCI World$ Index) valuations and underlying economic realities (G7 business confidence) indicates that a major shake-out in global equity markets is looming.

The All Share Index is trading at a discount to the MSCI World$ Index, but is reflecting relatively weak underlying economic fundamentals of South Africa, compared to developed economies. The JSE is as vulnerable as other markets to the looming shake-out.

My Global Risk Index has bottomed and indicates increased market risk ahead. The current momentum of the index suggests a continuation of the upward trend in the CBOE VIX (volatility index) or “fear index” that started in December 2017. High risk events are possible.

My Global Stock Market Indicator is on the verge of “Risk Off”. The current stage in the global investment cycle warrants a very cautious stance. SA investors could be more comfortable from a risk point of view by concentrating on dual-listed offshore non-cyclical equities, consumer staples, communication, healthcare and rand-hedges.

From the economic and financial indicators it is apparent that the equity markets are in denial of a downturn.

(The above are the takeaways from my Economic & Investment Insight Report for the second quarter, which will be available soon.)

Ryk de Klerk is an independent analyst-at-large. Contact rdek@iafrica.com. His views expressed above are his own. You should consult your broker and/or investment adviser for advice.

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