Be prepared for several more months of struggle as markets fret about Europe. But next year, the markets are going to be focused on China.
The past few days—and in particular, October 6 and 7—have shown investors how markets are likely to work in at least the first half of 2012.
You need a little stock-market history to flesh out the past few days and turn them into a road map for the next nine months or so, but I think the outlines are there.
I’ve written recently about the likelihood that sometime in 2012, the emerging stock markets of China, Brazil, and the rest of the gang will decouple from the slow-growth developed economies and start growing independently. And they will drag the commodity economies of Australia, Canada, and the rest of that global group along with them.
Around the middle of 2012, it will become clear enough to investors that China, to take the core case, isn’t headed for a hard landing, and that growth of 8.2% to 8.5% is indeed the likely bottom for this cycle.
Global cash flows will move toward economies showing that kind of growth, and out of developed stock markets where growth is stuck near 1% to 2%.
At that point, emerging stock markets will reverse the underperformance of November 2010 to now and begin to outperform their developed-country counterparts.
But what about the nine months or so (and maybe longer) until that certainty and outperformance arrive? What happens then?
This is where the action of the last few days and the lessons of stock-market history can suggest the likely details.
The Pace of Things
What we’ve seen in the bounce, or rally, or whatever, of the last few days from the stock markets of the developed and developing economies hasn’t been a decoupling—Hong Kong’s Hang Seng Index hasn’t gone up while the US Dow Jones Industrial Average has gone down—but rather a multiplication.
When the US markets moved up on Thursday, emerging markets rocketed ahead even faster. When the US markets pulled back a bit on Friday, emerging markets that were open when the US markets were, such as Brazil’s Bovespa, retreated even faster.
This is a classic emerging markets/developed markets pattern. Most of the time, when developed markets do well, emerging markets do even better. When developed markets do poorly, emerging markets do even worse.
And emerging markets outperform and underperform with significant lead times; they tend not to lag the developed markets, waiting for them to get going, but to precede them. They stage their initial rally while recovery still seems just a hope in developed markets.
(Much recent academic research has focused on whether, once you adjust for risk, emerging markets outperform enough in the good times to make up for this higher volatility. The conclusion reached by the papers I’ve read is that the risk-adjusted outperformance more than makes up for the additional downside risk. In other words, emerging markets can be very, very scary, but the emotional strain is worth it.)
So in 2008, China and the rest of the world’s emerging markets began to outperform developed markets with the catalyst, I’d argue, of China’s huge post-Lehman stimulus package. Developed markets wouldn’t hit bottom until March 2009.
In 2010, emerging markets hit all-time highs in November. Developed markets wouldn’t hit their peak until April 2011. From November 2010 through the beginning of the current bounce, emerging markets have lagged developed markets by 17%, the Financial Times calculates.
A simple formula might be: When fear recedes enough for investors to take on more risk, stocks all around the world move up—and stocks in emerging markets move up fastest.
When fear returns, as it did with Friday’s downgrades of the government debt of Italy and Spain and of banks in the United Kingdom, stocks around the world fall—and stocks in emerging markets fall hardest.
What this tells me is that for the next nine months or so, emerging-market stocks will want to move up, recovering some of the ground lost since November 2010. But that they’ll find it hard to make lasting progress if news from the United States and especially Europe keeps periodically scaring the devil out of investors.
NEXT: All Eyes on Europe
|pagebreak|All Eyes on Europe
In my read, for example, if the leaders of the Eurozone continue to look like (note I said “look like”—appearance is all, at least for a time) they’re making progress toward finding a way to fund the operations of the Greek government, toward buttressing the capital of European banks, and toward approving the expanded powers for the European Financial Stability Facility agreed to way back in July, then the global financial fear-o-meter will move lower.
Developed stock markets will continue to march ahead, and emerging markets will perform in overdrive as they work to make up their valuation discount to developed-market stocks.
Such a positive stage has a good chance of lasting through the end of October, when the officials from the International Monetary Fund, the European Central Bank and the European Union deliver their report on the Greek austerity program and European leaders finally approve the next $11 billion payout to Greece.
During this time, investors are also likely to be cheered by talk of requiring banks to raise more capital and promises that European governments (or someone) will stand behind stressed banks.
November, in this scenario, is likely to be a transitional month where positive momentum gradually meets with a return of old doubts. (And remember that the US supercommittee charged with coming up with a big plan for big reductions in the US budget deficit is supposed to report. Odds are, this process isn’t going to reassure global markets.)
Doubts that may begin to resurface in November will likely be well on the road from doubt to fear in December. Greece will move back into the headlines, since the country will need another cash infusion.
If you thought the Germans, Finns, and Dutch—the taxpayers in the AAA-rated countries that supply credibility to the AAA rating of the European Financial Stability Facility—thought giving Greece $11 billion in October was just throwing money down a rat hole, think about how they’ll react to yet another call for cash.
In December, though, financial journalists and analysts won’t be able to say reassuring things as they did in October, such as “Greece needs the $11 billion to pay government salaries and pensions, but the country doesn’t face big payments to bondholders until December.”
The calendar will now read December, bondholders will need to be paid, and the consequences of missing a payment won’t be riots in the streets of Athens but an actual Greek default.
The Road to a Greek Default
Because Europe’s banking systems won’t be ready for a Greek default by December, odds are that Eurozone leaders will successfully kick the can down the road one more time. But the limits of this game will be increasingly obvious to all. And I’d be looking for a Greek default in the first half of 2012.
That will send the fear-o-meter higher again—which won’t be good for developed- or emerging-market stocks. The consequences of a Greek default are just too unpredictable—and it’s unlikely that the Eurozone’s warring politicians will be able to reassure investors with a clear road map for handling that default.
I’d look for the US market to catch up with other global stock markets during their next outbreak of fear. Most of the world’s stock markets have already fallen to their 2010 lows. The US market looked as if it were headed to those levels in late September, but it bounced after breaking below 1,120 on the S&P 500.
The July 2010 lows on the S&P 500 were in the range of 1,010 to 1,030—depending on whether you look at intraday or closing lows. It strikes me as unlikely that the US market would be the only global market not to test its 2010 lows.
Who Comes Out on Top?
Meanwhile, as all this to and fro-ing on the global fear-o-meter is taking place, with the volatility for global markets that it entails, China will be moving toward a clear demonstration of where the bottom is for its growth.
There have been recent signs that Beijing is moving faster to reaccelerate its economy than looked likely six months ago. The People’s Bank of China has moved to peg the renminbi more tightly to the US dollar, reducing even the slow appreciation of China’s currency against the US dollar.
The last time China did this was in 2008, in preparation for its big post-Lehman stimulus package. This time, economists speculate, tightening the peg could be preparation for a change in China’s monetary policy that might include interest-rate cuts and a decrease in bank reserve requirements.
In addition, China’s leaders have recently begun to talk in terms that suggest a recognition that the country’s credit crunch has gone too far.
Speeches have exhorted banks to do more to lend to small and medium-size enterprises that have long complained that the pain of the credit crunch has fallen mostly on them. (Big state-owned or politically connected companies are having no trouble getting bank loans, they say.)
The reversal—China’s leaders now talking of a need for more lending—is dramatic evidence that a change in policy is brewing.
When that change becomes official (and when investors see that China has moved to put a floor under growth) is the critical timing issue for 2012. It depends on whether official inflation numbers continue to fall, for example. But at the moment, I’d say the middle of 2012 seems a reasonable timeline.
And that kind of certainty about China’s economy would do a lot to help the global fear-o-meter move down from any high caused by worries about a Greek default (or an actual Greek default). A realistic promise of more global growth wouldn’t fix the Greek economy or budget, but it would remove one big worry—that we’re headed for a global recession—from a very long list of investor concerns.
Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. The mutual fund I manage, Jubak Global Equity Fund, may or may not now own positions in any stock mentioned in this post. For a full list of the stocks in the fund as of the end of June, see the fund’s portfolio here.
