The massive global market rally rests on a knife-edge, as signs of sluggish consumer demand in rich countries threaten to puncture sky-high valuations in bond and equity markets, analysts warned this week.
“The market rally has, in some cases, gone beyond what would be warranted on the basis of the outlook for fundamentals,” said Mohamed El Erian, co-chief executive at Pimco, in an interview with Emerging Markets.
Fears of a sharp correction in risky markets are growing after fresh signs that weak consumption will drag down the economic recovery in the US.
Emerging market stocks this week followed the sell-off in Western markets. Spreads on hard currency sovereign bonds this week widened by 15bps to 341bp, and key currencies also fell.
On Thursday, US manufacturing was dealt a major blow as the Chicago purchasing managers index (PMI) posted a decline of 3.9 points to 46.1 in September.
This was below the consensus expectation of 52.0 and demonstrates that as US producers reinvested, consumer demand stalled last month.
As Emerging Markets was going to press, all eyes were on the US non-farm payrolls data expected late on Friday. Market jitters are based on fears over the fragility of the US economic recovery, as consumption – the key driver for US growth – remains feeble.
But despite this softening in market tone, emerging markets have largely weathered the US equity sell-off, Paul Biszko, senior emerging markets analyst at RBC Capital Markets, said. “Markets have priced in, and continue to price in, an optimistic growth scenario, despite this worrying data.”
After massive rebounds in the second quarter of the year, emerging stock markets have maintained their ascent but at a slower pace. The MSCI Emerging Markets Index gained 20% in the third quarter of the year, compared with a 34% jump in the second period. Hard currency sovereign bonds are now not far from levels seen just before the September 2008 crash of Lehman Brothers.
The combination of “zero short-term interest rates, which push investors into higher risk assets, and massive liquidity injections” has caused markets to price in a “V-like economic recovery for 2010,” El Erian said.
In many cases global stock valuations are not based on “sustainable” drivers based on “private components of aggregate demand” but temporary liquidity stimulus policies from G7 central banks and a bounce in restocking of inventories, El Erian argued.
Emerging market equities, on a price-to-earnings basis, now trade at the same valuation as developed stocks or at a slight discount on a forward price-to-earnings basis. Biszko argued that emerging market stocks and bonds can continue to trade tight, while lax monetary policies remain, “as no-one is thinking of withdrawal of liquidity stimuli now”.
But the bigger the rise, the greater the fall. Barry Eichengreen, professor of economics at UC Berkeley, warned that the history of emerging markets with their traditional “lack of transparency and poor governance issues” suggest investors should beware that profitability of listed firms and corporate issuers is far from guaranteed, despite the more positive economic fundamentals.