Are present market valuations justified by forecasts of growth?

Hopefully the market’s optimism over the Washington negotiations will prove correct and the US economy and global markets will not collapse. But that does not mean that the present valuations are justified by forecasts of growth both for the global economy and corporate earnings

On Thursday, the US markets had one of their best days this year. World markets across the globe followed suit. The reason is that the US has ‘solved’ its debt limit crisis. Of course, the ‘solution’, which has only been proposed, was not really a solution. It was just a proposal to delay the decision for an additional six weeks. It did nothing to get the government working. It provides no fiscal stability to help businesses invest. It simply guaranteed that we will again be entertained with Debt Ceiling II, the sequel. Besides, the proposal was not accepted by anyone and the parties are still deadlocked as of Sunday. But it doesn’t really matter, does it?

Despite the shenanigans in Washington, the easy money policies around the world are promoting lasting growth. We can count on easy money from the Federal Reserve. They have concluded, with brilliant circular logic, that any taper causes market conditions that make a taper impossible. So it goes on along with more money from the central banks of Japan, Europe and more loans from China.

Markets couldn’t be happier. With about 20 bureaucrats running the world, they are all up. Emerging markets such as India, Indonesia, and Brazil have all recovered from their woes of earlier this year by over 14%. The US markets are near their all time highs and European markets have risen by double digits this year. London and its financial markets have overtaken Germany as the leading market for Ferraris in Europe.

This implacable global growth ‘story’ has defeated any attempt at a correction. It goes something like this. Developing countries growth is indeed slowing, but is still quite vibrant. In the meantime, after years of slow growth or even recession, the developing world of the US and the Eurozone are finally beginning to recover. But is this really the case?

Apparently the IMF doesn’t think so. Its most recent World Economic Outlook has cut its forecasts for this year from 0.3 percentage points to 2.9%. Next year’s forecast was cut from 0.2 percentage points to 3.6%. This forecast is down from the last one in barely two months ago. But that is not the bad news.

The bad news is: this is the sixth consecutive downward revision from the IMF. But it gets worse. In Chapter 1 or the report page 12 chart 1.13, you will find something truly disturbing. The chart shows forecasts made in 2008, 2009, 2010, 2011 and the most recent. There are five charts: one for Japan, Euro area, US, developing Asia and Latin America. With the possible exception of Japan, the most recent forecast is way below all of the others. In light of the new forecast all of the old ones look wildly optimistic.

The strains are beginning to show. A measure of 21 key risk indicators for Asia covering everything from investor complacency to bank to bank trust shows systemic risk on the rise. The most disturbing is a spike in borrowing costs and default swaps for some of the region’s largest banks. This is especially troubling because any problems with Asia’s banks will be transmitted globally. Cross border lending to emerging markets surged by $267 billion to an estimated $3.4 trillion in the first quarter of 2013, according to the Bank for International Settlements.

This was not supposed to happen. The numbers from early September were relatively good. China’s manufacturing and services indexes showed impressive gains and Europe turned positive. But the trend did not continue. The rate of growth in Chinese manufacturing slowed to a fractional pace. Exports fell 0.3% in September compared with the year-ago period, sharply down from 7.2% growth in August and far below expectations of a 5.5% expansion. This trend does not bode well for the famous restructuring, where China’s growth is supposed to pivot from infrastructure spending and export to consumption. Worse the recent growth was based on the shadow banking system whose share of financing rose from 11% in 2011 to possibly 25% today. According to the World Bank, “China’s credit boom may have run its course”. But not to worry! The Chinese assure us that their economy will beat estimates and grow at more than 7.5%, and they probably know the numbers before they are published or even created.  

One of the recent stars in the emerging markets was Mexico. Tied to a slowly growing US economy without the problems of Brazil, it was supposed to do quite well. It hasn’t. Its economy was forecasted to grow at 3.5% last December. The most recent official forecast is less than half that at 1.7%. Private forecasts have been cut to 1.1% partially because US demand for Mexican products has been unchanged for several quarters.

Brazil has gone from one of the most promising emerging markets to one of the weakest. Unfortunately it did not use the boom years to reform its economy. So it boasts the world’s most burdensome tax code. Large durable goods like cars and appliances can cost 50% more than in other countries. Consumers pay 21% of their incomes to service their debts. The infrastructure especially the roads, railways and ports are woefully inadequate. In addition, it has a large deficit. A problem it shares with Indonesia, Turkey, South Africa and India.

Manufacturing data from companies around the globe last month was very uneven. While data from the US was positive other countries were not as strong. Indonesia had a good month in August, but the September numbers were not encouraging. Imports fell 5.7% and exports fell by 6.3% both missing estimates. Korea had the same problem. Its imports fell by 3.6% and its exports fell by 1.5%. Manufacturing production figures for Europe were just as discouraging. They fell or missed estimates in France, Belgium, Italy and Sweden. The only country that rose was Germany. Manufacturing data for Asia was not much better. It was basically flat for India, China, Singapore and Australia for most of the summer. Whatever the outcome of the US political standoff, the episode is sure to have made a dent in the real economy.

In a recent interview with the Financial Times, Nassim Taleb, the author of the famous “Black Swans” was asked if the global financial system was more prone to a ‘black swan’ or improbable tail event than in 2007. His response was that it was more fragile. It was a more vulnerable one because the bureaucrats running the system have no risk exposure.
They won’t lose their jobs or pensions if things go wrong. So they are free to work on programs like Quantitative Easing, which Taleb regards as a ‘scam’. Taleb’s point is very relevant to the present situation. Simply because an event is unlikely, it does not mean that it won’t happen. They do happen. Hopefully, the market’s optimism over the Washington negotiations will prove correct and the US economy and global markets will not collapse. But that does not mean that the present valuations are justified by forecasts of growth both for the global economy and corporate earnings.


(William Gamble is president of Emerging Market Strategies. An international lawyer and economist, he developed his theories beginning with his first-hand experience and business dealings in the Russia starting in 1993. Mr Gamble holds two graduate law degrees. He was educated at Institute D'Etudes Politique, Trinity College, University of Miami School of Law, and University of Virginia Darden Graduate School of Business Administration. He was a member of the bar in three states, over four different federal courts and has spoken four languages.)

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