Saturday 7 December 2019

Bear trap: are markets correcting or in chaos?

Is this the beginning of the end?
Is this the beginning of the end?

Colm Kelpie.

British banking giant RBS made headlines last week when it forecast a catacylsmic year of doom and gloom due to disappointing global growth, the plunging price of oil and the Chinese slowdown. But some experts don't share its deeply pessimistic view of what 2016 holds for investors, writes Colm Kelpie.

Brace yourself. You think you're a little bit more confident about the state of the economy and your finances?

Forget about it. The world economy is getting increasingly rocky again.

At least that's what the Royal Bank of Scotland, the parent company of Ulster Bank, feels. Its doomsday-scenario note to clients from credit chief Andrew Roberts last week made headlines globally for the sheer extent of its pessimism.

"The world is in trouble," Roberts glumly warned. On the back of a turbulent and chaotic start to the year for global markets, investors were urged to sell almost everything and essentially take to the hills.

"We have been warning… that this all looks similar to 2008," Roberts' assessment said, referring to the year US banking giant Lehman Brothers collapsed, precipitating the global financial crash. Investors, RBS said, should be afraid that the bank's ominous outlook, put out as recently as November, had "been borne out over the past six weeks".

And the reasoning?

The world economy is slowing, trade is slowing, credit is slowing, we're in a currency war and global disinflation is turning into global deflation as China devalues the yuan, while the US looks at further hiking rates, RBS said.

Stocks will fall by up to 20pc. Oil will trade as low as $16 per barrel and emerging markets will crumble.

"For the world, the game is up," it said.

It doesn't get much more bleak than that, especially coming just days after dramatic volatility on the Chinese markets, wiping billions from shares around the world, cast the spotlight on the health of the world's second-biggest economy.

And considering the way the markets ended last week, you'd be inclined to say the British banking giant actually may have a point. Plunging oil prices sent global stocks sharply lower on Friday, pushing major European stocks to a one-year low and into bear market territory. The Stoxx Europe 600 Index closed more than 20pc from its record high in April, meeting the definition of a bear market, where prices are falling.

Brent crude prices, which have fallen 20pc this year already, were down around 5pc as the market prepared for oil from Iran to flood an oversupplied market.

RBS's analysis that oil would fall as low as $16 per barrel looked almost conservative amid forecasts from other big banks, like Standard Chartered, which predicted a drop to $10.

Crude oil's drop to a 12-year low is sending shockwaves around the world. It's good for consumers, yes, but not so for the industry or the global markets as investors remain jittery.

Norway sees a crisis in its industry, energy firms are laying off workers and currency markets from commodity-producing countries are in turmoil. The sharp falls are also affecting the outlook for inflation around the world, leaving analysts to wonder just how far the United States will raise rates this year.

"Oil is deeply oversold. The stock market is deeply oversold. The inability for the market to rally from deeply oversold conditions clearly tells you how weak the market is," Adam Sarhan, chief executive of Sarhan Capital in New York, was quoted on Friday by financial newswire Reuters.

RBS's analysis may be bleak, but the signs suggest that it's not for nothing. So how worried should we really be at this stage? Is RBS simply telling it as it is or is its pessimism just all headline-grabbing doom and gloom?

It's a bit of yes and no.

Analysts and economists agree that the world economy is facing into a year of considerable risks.

On top of the plunging price of oil and the slowdown in China, there are signs of wobbling in the UK economy. The eurozone may be coming around gradually, but more stimulus is expected from the European Central Bank (ECB) this year.

Brazil and Russia are in recession and tensions in the Middle East are unnerving investors ever so slightly.

But as with all forecasts, there are differing views on the extent to which all of this will impact on the global economy.

There are risks, of course, even big ones, perhaps; but many commentators see the RBS note as being overly bleak.

Stephen Koukoulas, managing director of Australian consultancy Markets Economics, has publicly challenged Roberts to a A$10,000 wager to "put his money where his mouth is" and bet whether the latter's predictions will pan out.

Other analysts and economists haven't been quite so outspoken, but they're sceptical nonetheless. Robert Pavlik, chief market strategist at Boston Private Wealth, is certain that RBS has it all wrong.

"Unless they think we're going into a protracted economic recession, similar to what we experienced in 2008, why would I sell everything?

"If I'm a long-term investor, I have to be prepared to ride out periods of market volatility, not only in the domestic economy, but in the global economy," he told the Sunday Independent.

"Things are not overly optimistic right now, but neither am I overly pessimistic."

The state of the global economy will be dominating discussions high up in the Swiss Alps this week, where politicians, the rich and influential - including Taoiseach Enda Kenny - gather for their annual talking shop and networking opportunity.

The World Economic Forum in Davos will be full of predictions about how matters are going to play out. Undoubtedly, one of the most in-demand guests this year will be Fang Xinghai, the vice chairman of the China Securities Regulatory Commission, whose job it is to supervise the various ups and downs of the stock markets in the world's second-biggest economy.

He is appearing on a panel discussion on how China's economy can "shift gears without stalling" that also features Ray Dalio, the founder of the hedge fund Bridgewater Associates, and Christine Lagarde, the managing director of the International Monetary Fund (IMF).

For Kieran McQuinn, associate research professor at the Economic and Social Research Institute (ESRI), China is the big unknown facing the world in 2016.

"It's so big that it's hard to know exactly how it's going to pan out, but how it will unwind is the real uncertainty there," he says.

"We've been struck by Willem Buiter [chief economist] of Citigroup, who wrote a piece toward the end of last year, which was fairly hawkish in terms of what he was saying about China. He was forecasting a hard landing. I think the turbulence you're seeing in stock markets is indirectly linked to that.

"There's excess capacity in a lot of sectors in the Chinese economy, excess leverage in the private sector and then there's huge irrational exuberance in asset markets. They have a credit bubble of all credit bubbles.

"He [Buiter] has forecast a hard landing for China this year and that's sticking his neck out, but he may not be so far off the mark."

From the second-biggest economy to the world's biggest, what's happening in the US this year will also have ripple effects, be it the rise in the dollar or the increase in interest rates.

Although the euro has been fighting back over the last week, the value of the dollar has been rising strongly. On Friday, €1 was worth $1.09, compared with $1.39 in March 2014.

Philip O'Sullivan, chief economist at Investec in Dublin, says the strengthening greenback will have a knock-on effect internationally.

"One of the key consequences of the divergent monetary policies on show from the world's leading central banks - tightening in the US, loosening in the eurozone and seemingly 'on hold' in the UK - is the ascent of the US dollar.

"If this continues or accelerates, it will become a drag on global growth, but we believe that the monetary authorities are monitoring this closely and are prepared to fine-tune their policy stances if they see this playing out."

For McQuinn and O'Sullivan, the RBS note was a little apocalyptic.

"They [RBS] could be quite right and there could be huge volatility in stock markets, but that may not have the knock-on implications for the real economy and the traded sectors overall," McQuinn says.

"If there are these difficulties in global trade and emerging-market economies, they'll affect us indirectly. They'll affect us through the UK, the US and Europe, but not so much directly.

"We [the ESRI] would still think that on balance… the US economy is set to perform quite well this year, the UK growth outlook may not be as positive as it was, but overall we see sufficient growth amongst our main trading partners to think we're still going to get a lot of growth from external trade.

"We'd still think that the outlook is reasonably favourable for the Irish economy.

"All the indicators have been very strong and positive and at this stage we really wouldn't think that there's any reason to revise our outlook."

Overall, O'Sullivan believes global growth concerns are "overdone". "It is clear that the mood in the markets has become more cautious since the start of 2016," he says.

"Indeed, the drop in share prices reflects a genuine, not misperceived, rise in the risks to our benign 'central case' outlook.

"To assuage the current concerns, we will need a period of stability (at least) in the energy markets and/or China.

"Not having a crystal ball to hand, like other market participants, we are unclear on the timing of this happening."

But he doesn't see what he calls a "China-geddon".

"We think the country is managing its way through its growth transition broadly according to plan," O'Sullivan adds.

"Rebalancing an economy is a high-wire act, though, which explains some of the nervousness. But we would highlight that a lot of the narrative around China at this time is incomplete.

"For example, while there has been huge coverage afforded to the fall in the Chinese currency relative to the US dollar, on a trade-weighted basis it is close to an all-time high.

"Secondly, China's central bank, the PBOC, has vast reserves to intervene with in order to support its currency if necessary.

"Thirdly, while Chinese economic data, in general, has weakened, it is not synonymous with a severe contraction."

And while the plunging price of oil may not be good for producers, it's a boon for consumers as it represents an effective "tax break", he adds.

"The longer prices remain weak, however, the greater the risk of adverse developments in financial conditions - a major bankruptcy in the energy sector would likely result in more nervousness on the part of lenders across the board.

"But this isn't likely to lead to the sort of 'domino effect' that contributed heavily to the global financial crisis. Remember, banks are better capitalised than they were before the great recession, while risk-management protocols have been tightened up, allowing for more judicious lending than before."

In fact, in the volatility there may actually be some positives for investors.

Short of the 'sell almost everything' mantra from RBS, Scott Corfe, a director with the London-based Centre for Economics and Business Research, believes there may be buying opportunities in the current market and that some sectors are really not doing too badly.

"The services sector in the UK is doing quite well, even though we've had some dismal manufacturing data," Corfe says.

"Similarly, in China, manufacturing is contracting, the industry side is doing very poorly, but actually if you look at some of the services data from China, it is more encouraging," he says.

"So it's a bad year internationally for manufacturing and for production and for commodities, but I think a lot of the service economy is doing quite well."

But Corfe's a little more downbeat on the global economy, though not perhaps quite in the RBS league.

"I think it's right to be very cautious about the world economy and there's clearly a lot of risks out there," he says.

"There are substantial downside risks, but I don't think we're back in that 2008 scenario."

It's only the middle of January and considering the level of volatility already this year, it's hard to call it too definitively.

But Pavlik of Boston Private Wealth doesn't think so.

"I think overall the markets will stabilise, see some volatility and stabilise and then see some volatility," he says.

"I think it's very bad advice to come out and say sell everything.

"It's like yelling fire in a crowded movie theatre. It doesn't make sense."

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