Weekly Wrap

A New Beginning?

Calendar Icon   Friday, 15th January 2021

Economy vs Share Market

With the beginning of a new Presidency in America, there is a train of thought that believes the new administration will begin a spending spree to help the economy recover. Currently, the share market in America is at record highs with any number of measures at record levels as well.

The conventional thinking amongst economists (which is based on backward looking outcomes), is that this new spending will create inflation, which will be linked to a rise in interest rates. Considering that the world debt ratio is currently sitting at 365% of GDP (up from 320% 18 months ago), rising interest rates would be unpalatable, to say the least.

The current view from the major research houses is that interest rates on US 10 year bonds could reach 1.5% this year. The problem with this thinking is that the yield has doubled to 1.1% since October 2020, the highest level in some years.

Higher interest rates would create havoc for Central banks and the quantitative easing programs currently employed. Any tapering of these programs would severely impact the easy liquidity that the banking sector has enjoyed since 2008.

Whilst the share market has been enjoying the easy liquidity, the economy has been suffering from the pandemic that may or may not abate in 2021. The virus has shown the ability to mutate into faster transmission and the effectiveness of vaccines is yet to be proven.

One of the major beneficiaries of the zero or negative interest rates has been the zombie companies in America that are surviving by issuing new bonds to pay existing debt. The market has been lapping up these issues but rising rates would put them at severe risk of defaulting.

Rising interest rates would also affect the current tech stocks that are listing on profits but with valuations that would make pyramid scheme promoters blush.

The Buffett Index, which simply measures the ratio of stock market wealth to GDP has reached 153% for America. This easily surpasses valuations seen prior to the tech wreck of 2000 and the stock market crash of 1929.

The signs are obvious that the globe is in the midst of a financial bubble. Debt is too high, government spending is off the charts, yet markets have ignored this obvious disconnect to forge higher.

Of course the current commentators, who are still bullish, are rationalising that the increased use of technology and working from home is offsetting the economic weakness seen in city centres and empty offices. This is common at the end of bull markets as the positive mood sweeps everyone up.

Money Supply Contraction

When the social mood starts to turn pessimistic, the lending activities of both lenders and borrowers become cautious. A recent article in the South China Morning Post (Dec 29, 2020) states that the retail sector “fell off a cliff”, with loan rejections for consumers and small businesses increasing by 38% and 24% respectively.

For an economy that is tightly controlled by the CCP, this is unwelcome news. A decrease in lending is generally accompanied by falling prices and last November prices in China fell into negative territory for the first time in 11 years. (See below).

China's consumer inflation rate

There have been rumblings out of China about the deteriorating quality of the Chinese credit market. Whilst this is hard to determine the accuracy of, it also coincides with a recent banning of goods from Australia, based on questionable quality issues. Perhaps the demand for these goods has evaporated?

The share market has a habit of moving too high or too low and can do so for extended periods. Unfortunately for the majority of people, they tend to forget what happened immediately after these extremes. Opportunities exist in going against the herd when the herd is seemingly unstoppable.