Of the key market puzzles, the robustness of Chinese stocks and the unnerving resilience of the euro stand out.
The explanation lies in relative liquidity trends. The ECB has talked compromise but squeezed liquidity hard whereas in contrast, the Chinese have talked tough on inflation, but latest evidence confirms easier liquidity. The next six months could see leadership from Shanghai stocks and a much weaker euro and emerging markets will take succour: we are overweight again.
The latest liquidity trends show gradually rising EM liquidity and gradually declining DM, coloured by the remarkably tight liquidity position at the ECB. Our Global Liquidity index stood at 65.2% at the end of June 2011. Almost every major economic region, but most noticeably the US, enjoyed a jump in private sector liquidity in June, largely because savings and cash flows picked up as economies slowed, rather than from any significant uptick in credit growth.
World Central Bank liquidity remained high at an index value of 59.5%. US Fed liquidity appeared to peak in May and it inched lower through June, 2011. Bank of Japan liquidity injections have slowed slightly from their post-Earthquake surge, but our Bank of Japan index remained at a high 80.4%.
In contrast, ECB liquidity cratered to a suicidal 2.6%. More reassuring is the continued high levels of the People’s Bank of China’s liquidity at 61.2%, which although a tad lower than in May are well ahead of their 32.5% score of a year ago and up on the near-50% level of three months back. We are optimistic that any overall tightening will be mild and ultimately, we envisage QE3.
The world economy will settle back to dull trend growth during the second half of the year. The supply disruption from the Japanese earthquake will wash out, but these positive effects will struggle to offset the fall in the liquidity cycle. Low inflation, the main factor underpinning valuations, looks set to continue despite the latest small uptick in core inflation rates.
There is no ‘new normal’. The world changed twenty years ago following the fall of the Berlin Wall and the subsequent economic enfranchisement of two to three billion people worldwide then living under the yolk of market-unfriendly political regimes. These two facts will hasten the economic catch-up of emerging markets and simultaneously the eclipse of the West. The former must favour emerging stock markets and currencies, while the latter will undermine Western debt markets and currencies. Both trends will underpin gold and commodity prices.
Primary up-trends in commodity markets and in emerging markets set to continue, after testing trends in 2011. Gold (and oil) are likely to double from current levels on a five-year view; emerging market equities to outperform developed by an average 2% to 3% points each year. Despite a cyclical pick-up in energy and food price inflation, significant cost deflationary pressures emanating from emerging markets will cap Western price indices in the medium term.
