Tuesday, 12 August 2008

Lower Oil & Interest Rates No Market Panacea

The bottom is in for the stockmarket, didn't you know? Oil has shed more than 20% in the last month. Add to that the RBA now has an easing bias and you have a powerful catalyst for stocks. If only it were that easy.

As is my penchant, I will take the opposite side of this trade, not for the sake of being a contrarian but because there is plenty of evidence to suggest the stockmarket is far from a bottom.

Firstly why is oil falling? Is it those damn speculators? Funny how we don't blame the speculators when oil drops, apparently it's demand destruction, now if it is demand destruction, what does that tell you about the health of the global economy? This is what it tells Marc Faber:

Investors speak of weak oil price as being bullish but the point is that it signals the global economy is in recession already.

I absolutely concur. Is the global economy really headed for recession? Rather than me try to answer it I will let Nouriel Roubini explain :

Let's detail why we a global recession is now likely...This global recession is being fed by a variety of factors: the bursting of housing bubbles in many economies (US, UK, Spain, Ireland and other. Eurozone memebers); the burst of massive credit bubbles in countries where money and credit used to be too easy for too long and supervision and regulation of credit too loose; the severe credit and liquidity crunch following the US morgage and debt crisis; the most severe financial crisis since the Great Depression (not as bad as the Great Depression but second only to that episode); the negative wealth and investment effects of falling stock markets (that have already fallen globally by a bearish 20% plus); the burden of high oil and commodity prices for commodity importing economies; the global effects via trade links of the US recession (as the US still counts for about 30% of global GDP); the weakness of the US dollar that is reducing the competitiveness of countries exporting a lot to the US; the stagflationary effects of high oil and commodity prices forcing central banks to increase interest rates to fight inflation at a time when there are severe downside risks to growth and to financial stability.

In the US data suggest that the economy entered into a recession in the first quarter of this year as the five indicators used to define a recession (GDP, employment, production, income and sales) all peaked and then contracted between October 2007 and February 2008. The economy rebounded - in a double-dip W-shaped recession - in the second quarter boosted by the temporary effects on consumption of $100 billion of tax rebates. But those effects will fade out by late summer while the more persistent factors hitting a shopped-out, saving-less and debt-burdened US consumer will remain: falling home values; falling stock prices; credit crunch in mortgages and consumer debt (credit cards, auto loans, student loans) ; rising debt and debt servicing ratios as mortgages and other consumer debt interest rates are resetting higher; high gasoline and food prices; collapsing consumer confidence; and, most important, a fall in employment for seven months in a row.

Similar factors are at play in the UK, Spain and Ireland where housing bubbles are going bust together with a bust of excessive consumer debt thus leading to a recession. But even in Italy, France, Greece, Portugal, Iceland and the Baltic economies frothy housing markets are starting to deflate. More broadly and ominously all of the Eurozone is now headed towards a recession including the three largest economies and G7 members: Germany, France and Italy. Bursting of housing bubbles; the effects of the liquidity and credit crunch that has also hit European financial markets and limits the ability of European firms to borrow, hire and invest; the fall of exports to the slumping US; high oil and commodity prices; the loss of competitiveness of Eurozone exports with a super-strong Euro; and the hawkishness of the ECB that - unlike the US Fed that aggressively cut policy rates - first kept rates on hold and has recently raised them to fight inflation. So no wonder that production, sales and consumer and business confidence are all falling in the entire Eurozone. And thus second quarter Eurozone GDP growth will be even worse - and close to zero - than the US while the future growth ahead looks even worse.
Of the remaining G7 economie Japan is already contracting. Japan used to grow modestly for two reasons: strong exports to the US and a weak yen. Now the exports to the US are falling while the yen is not as weak as before. On top of these two negative shocks two other shocks are pushing Japan into a recession: high oil prices for a country that imports all of the oil that it consumes; and falling business profitability and confidence.

The last of the G7 economies, Canada, should have benefited from high energy and commodity prices; but its GDP has already contracted in the first quarter. With a quarter of its GDP exported to the US and such exports being three quarters of its exports Canada's economy is totally dependent on a sick US economy that is contracting.

So literally every single G7 economy is now headed towards a recessionary hard landing. And now other smaller economies (mostly the new members of the EU that all have large current account deficits) are at the risk of a sudden stop of capital and reversal of capital inflows that could trigger a hard landing; such hard landing is already occurring in Latvia, Estonia, Iceland and New Zealand. This G7 recession will next lead to a sharp growth slowdown in emerging market economies and likely tip the overall global economy into a recession.

But how about Australia? At least we have the luxury of relative high interest rates to begin cutting from. However, just as interest rate cuts failed to stop the US from sliding into recession and stockmarkets from falling, so it will be down under.

Today's NAB business survey suggest business conditions are deteriorating shaply to levels not seen since 2001 whilst business confidence is at levels not seen since the last Australian recession.

Also, the RBA is now starting to sound worried:

Now the Reserve says it's worried
AUSTRALIA's Reserve Bank has expressed deep concern about Australia's economic outlook, presenting forecasts that suggest it might have lifted interest rates too high.

The RBA's latest quarterly statement predicts that economic growth is about to slow and that unemployment will climb to 6%.

The Reserve Bank warns that, while these are its central forecasts, and headline inflation is now expected to peak at 5% in December, any further deterioration in the global outlook could lead to a "significant deterioration" beyond those forecasts.

The RBA predicts that Australia's annual rate of jobs growth, at present 2.3%, will slow to three-quarters of 1% almost straight away. The forecast implies a jump in unemployment from 4.3% to 6% by the end of next year.

Australia's rate of economic growth, at present 3.6%, is forecast to slow to 2% by the end of this year, with about half of that coming from the mining and agricultural sectors, implying a paltry 1% growth rate in the rest of the economy.
But don't worry;

A member of the Reserve Bank board, former Woolworths chief Roger Corbett, told Sky News yesterday that Australia was "resilient" and had a strong, broad base.

Haha, where have we heard that one before?

In the US, despite the government's best attempts, the worst of the credit crunch is not over. Atl-A is the new subprime only it is much worse. There will be waves of mortgage resets in coming months and well into 2009-10. Also, right on cue, C&I loans are starting to deteriorate.

All this adds up to sharply higher delinquincies more bank writeoffs, dvividend cuts, capital raising and bankruptcies to look forward to over the next 12 - 24 months.

Now that the evidence is in, Martin Feldstein, former head of the NBER, (the organization that calls recessions) estimates that less than 20% of the rebate checks mailed out to the ailing US consumer were spent, confirming that such stimulus methods are next to useless.

All this hasn't stopped the cheerleaders from calling a bottom in the US housing and stock markets. Remember that these are the same geniuses who did not see a recession coming, did not see a bear market in stocks and were calling for a second half rebound in the US economy. A rebound, as predicted here, that has now been cancelled.

And don't fall for the crap that the stockmarket is currently undervalued. This weekend's financial Review devoted two pages to so-called experts who claim the market is cheap based on forward earnings.

As soon as you hear forward earnings you can usually stop reading. The US market looked cheap in November last year when analysts were predicting double digit earnings growth for 4Q07, 1Q08 and 2Q08. As we now know 4Q07 earnings plunged more than -30%, 1Q08 was down more than -25% and 2Q08 is now down about -23% with more reports yet to come.

Of course that doesn't mean we won't see the trademark bear market rallies of the short and sharp kind. Just don't get sucked into thinking the worst is behind us just yet or that more importantly, the stockmarket has discounted it.