Gary Dugan sees liquidity fueled exuberance

UAE. What a start to the year. As we end February investors can reflect back on year-to-date double digit returns from equities and some commodity markets. The DFM General index has rebounded 30% from the lows of mid-January.

It is clear that the massive flows of liquidity circling the world are being put back to work in financial markets. However it is always worth bearing in mind that rises in equity markets don’t in themselves solve the problems of economies. Note that Greece is still bordering on default.

Liquidity continues to be the main driver of the rise in markets. Last week’s European CentralBank (ECB) Long Term Refinancing Operation (LTRO) led to 800 banks receiving funding of an aggregate €539 billion for three years at a cost of just 1%. The banks are then going out and using the funding to buy Euro zone debt, which in turn drives down Euro zone bond yields.

Italy has been the chief winner from the ECB’s actions. The Italian 10 year bond yield has fallen by over 200bps since the start of the year. Whilst the cash seems to be finding its way into the financial markets, the only way the market rally can be sustained is if the cash finds its way into the Euro zone economy and drives growth.

Unfortunately Euro zone money supply growth – a good measure of the impact of money on the economy- is still weak. A growth rate for M3 (a broad measure of money supply) of just over 2.5% is very poor relative to many other parts of the world and not consistent with a recovery in the economy.

Liquidity will continue to play a major part in driving markets but after such a strong rally for markets to make progress needs ongoing upgrades to global growth forecasts. There is a new impetus in the emerging markets with strong industrial confidence indicators reported for Korea and Taiwan in recent days. In Korea the trade report showed exports up 33% at an annualized rate.

In Thailand industrial production was up nearly 20% month-on-month in January after an even stronger December. In contrast the US economic data has disappointed somewhat. The labour market continues to show improvement but industrial confidence slipped back after the recent strong consistent rise. In truth US economic data was so strong earlier in the year that it was going to be difficult for the data to keep matching best expectations.

The stronger data from the emerging economies is likely to reinforce the strong relative performance from emerging market equities and bonds. The only reservation we have is that the ongoing strength of the oil price could still deliver an inflation scare that slows the pace of monetary easing in many parts of the emerging world.

The original reason investors piled into emerging markets over the turn of the year was the prospect for cuts in interest rates, and the belief that Europe’s problems weren’t going to do systematic damage to the rest of the world.

In just a few weeks many of those interest rate cuts have been more than discounted with the risk that the rise inflation may stop some of those cuts in interest rates from happening. Not only is inflation posing a potential problem but Brazil for example is also trying to cope with significant inflows of capital that has led to upward pressure on the Brazilian Real.

The authorities have announced a series of measures to slow the rate of appreciation of the currency such as restrictions on companies issuing external debt as it encourages inflows of capital into the country. After such a strong start to the year there is a temptation to take profits on the Brazilian equity market.

In contrast to the challenges to the Brazilian markets, Russian asset markets could rally further post the emphatic win of Vladimir Putin in the Presidential election. In particular the Russian equity market could provide investors with further strong absolute gains.

Russian equities trade on an exceptionally low valuation (P/E of 6.3x). The oil price high and greater clarity on the political front should act as a catalyst for further strong performance. Many investors have been waiting for the election results before buying into the Russian financial markets.

In the meantime there has been a significant rally in Russian assets. The ruble has gained 9.7% against the dollar so far this year and the MICEX equity market index is up 15%. In the debt markets the cost of insuring Russian debt has fallen from a Credit Default Swap (CDS) level of 335bps October last year to 178bps. Some of the Russian credits have not kept pace with the rally in either frontier or emerging markets. We expect further good performance from Russian asset markets.

Greek problems have not gone away. A melt down in Greece still has the potential to have investors running to take profits on recent gains in risk markets. As we suspected the Greek situation is lurching towards almost inevitable debt default. It now appears likely that private investors will be forced to accept the terms offered them by the Greek government hence the Greek government will technically be in default.

Although the matter is very technical in practical terms the defaulting of debt will mean that Greek banks lose access to the capital markets.

The ECB has already announced that it will no longer accept Greek debt as collateral as security for new loans. Moody’s the credit rating agency cut the long-term foreign currency debt rating of Greece to C from Ca. For the moment the markets seem to have taken the news of probably default in their stride however we suspect that the default is only one further step of Greece towards its probably exclusion from the Euro zone.

Greece’s ongoing problems and some slippage in Spain’s to reduce their deficit have put the skids under the Euro. After trading as high as 1.3460 against the dollar the Euro has slid to 1.3188. A move back to the recent low of 1.2667 is still quite possible given the likely difficulties in Greece and the lack of new positive news post the latest round of liquidity support from the ECB.

Although oil and gold saw some profit taking in recent trading sessions we believe there is upside for both commodities. Another way of playing the rise in the oil price is through energy stocks.

The share prices of oil companies have not kept pace with the rise in oil prices. Indeed the gap between the performance the oil price and oil shares is quite exceptional. One of the challenges for oil stocks is that although oil prices have risen oil product prices have not risen as much.

Companies that are more reliant on petrochemical sales are being partially squeezed between high input prices – crude oil and not so high product prices (petrochemical prices).

Investors should look to invest in either actively managed energy funds or oil production companies.

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