Stocks were weak following the Fed announcement on June 19th, but they were also hurt the following day on a ‘weaker than expected’ manufacturing report from China, which showed a slowing of orders as well as some tighter restrictions on non-bank lending. However, investors completely over-looked the data out of Europe, which showed a continued improvement in the overall data. While still weak, the manufacturing and services reports from the Euro-Zone were ahead of expectations and much closer to a point which would indicate expansion rather than contraction. Taking Europe off the ‘critical list’ is more important right now than whether the Chinese economy ends up expanding 7.4% or 7.8% in 2013. China and the other developing economies of the world have decades of above-average growth still ahead of them. Urbanization is only just crossing 50% of the population in China. Developed economies have urbanization rates of 85-90%, suggesting many more years of people move to productive positions and growth of infrastructure.

The ‘Ying and the Yang and the Yen’ of Stocks and Commodities. Global capital flows have surged in recent years as giant hedge funds, sovereign wealth funds, major mutual funds and huge pension plans have become much more active investors, with many shorter-term trading strategies that are often driven by algorithmic computer models. This has increased the volatility of financial markets as these huge funds move between various currencies and markets, often at the same time. The ‘big trade’ from about 2005 onwards for many of these funds was to short the U.S. Dollar and put an offsetting buy on commodities (since commodity demand was growing and they were generally priced in U.S. Dollars). The trade worked on both sides as the Dollar continued to fall when the stimulus programs came in after the financial crisis in 2008 while commodity prices soared (gold prices moved from under US$500 in 2005 to a peak of US$1800 in 2011). That trade has clearly been unwound over the past two years as the U.S. Dollar has rallied against most global currencies and commodity prices have been under pressure from slower global economic growth.

The trade over the past year has moved to the ‘Land of the Rising Sun.’ A stimulus program by Japanese Prime Minister Shinzo Abe is a set of policy measures meant to resolve Japan’s macroeconomic problems. Nicknamed ‘Abenomics’, it includes a mix of reflation, government spending and a growth strategy designed to jolt the economy out of the suspended animation that has gripped it for more than two decades. The stock market has subsequently risen over 50%, consumer spending has pushed economic growth higher, and Shinzo Abe’s approval rating has ticked up to 70%. In effect, Abenomics is really like “QE3 on Steroids!” It is equivalent in size to the current Quantitative Easing in the U.S. but on financial markets that are about ¼ of the size. The big funds have played Abenomics by shorting the Japanese Yen and then going long (buying) U.S. and Japanese stocks. This has also pushed the U.S. dollar further ahead which, in turn, has been another headwind for commodity prices. The veracity of these flows can be seen in the increased volatility of the Japanese financial markets. When fears arose that the U.S. Fed might unwind its own stimulus earlier than expected, the reverberations were felt around the globe and traders unwound those Abenomics-related trades aggressively. The Japanese stock market, which had risen over 80% over the prior six months, fell over 20% in the ensuing three weeks! The normally less volatile currency markets were also shook as the Japanese Yen, which had fallen by almost 30% while their stock market was rallying, turned around and gained almost 10% while stocks fell.

The bottom line is that the ability of capital to move more quickly is causing volatility to increase correspondingly. What seems to be missed though is the fact that Abenomics appears to be working. The economic data in Japan has clearly improved recently with exports growing, industrial production increasing and consumers spending. The net result has been first quarter GDP growth of 4.1%, well ahead of the 3.5% expectation. With U.S. growth strong, Europe beginning to recover, China having above-average growth for many years and now Japan, the world’s 3rd largest economy, starting to show some stronger growth, the global economy could have its four largest components all growing at the same time. Japan has not been a force to reckon with on the global economic scene for decades, so this could surprise investors in a positive way. The Fukushima disaster occurred in March 2011, which lead to a contraction of over 10% in the Japanese economy over the ensuing six months. Not coincidentally, that also coincided with the peak in commodity prices and the basic materials stocks, which have sold off sharply since Fukushima. A return of growth in Japan could reverse that commodity decline as industrial production picks up and imports increase.

Economic volatility has actually been decreasing over the last two years despite the impression that financial markets are much more volatile. For the first half of 2013, the U.S. has been facing the headwind of the ‘fiscal drag’ from the sequestration; this will dissipate in the back half of the year. Lower economic volatility will allow risk assets to increase in value and for multiples to rise, even as the QE program starts to be withdrawn. Using 4.5% normalized 10-year yield for U.S. bonds, steady earnings multiples and a conservative estimate of 2013 earnings, the S&P500 would be at historical fair value today at 1850, more than 16% above where that index is trading today.

1 2 3 4