A review of financial markets from Citibank
In Q2 this year, market volatility significantly grew, while the value of high-risk assets fell. From May to June MSCI World lost 8.3% and the trend still continues. Volatility indicates that investors are now balancing between a high level of optimism brought about by a period of positive market dynamics, on the one hand, and economic figures that have been deteriorating lately, on the other.
The dynamics of the Economic Surprise Index is among the most important indicators monitored by Citi analysts. An economic surprise represents a difference between the actual and expected value of an economic figure. History confirms a close dependency between short-term yields of financial markets and the dynamics of the Economic Surprise Index: stock prices and bond yields, as a rule, grow on positive economic surprises, and vice versa. Despite a Q2 lag in stocks, Citi analysts observed a discrepancy between stock and bond dynamics and the ESI. Indeed, the ESI plummeted, AAA bond rates fell, while stock prices demonstrated surprising stability in the context of worsening economic figures. Citi's Global Investment Strategy Committee treats this discrepancy as a sign of excessive investor optimism in the stock market. A noticeable difference between investor sentiment and economic figures drives one to think about the degree to which the market stability is based on expectations of growth in fundamental indicators and, on the other hand, on investors' delusions.
Delusion 1: US Fed's quantitative easing program was successful
When analyzing portfolio dynamics for the past two years it may seem to investors that US Fed's quantitative easing (QE) program was a very successful step because stocks rose during both QE phases. Nevertheless, maintaining the yield of financial markets was not among the QE program's objectives. It was intended to restore crediting of households, maintain property prices and lower unemployment rates. The volume of credits received by households consistently reduced during this period, property prices stayed around the trough of the mortgage crisis in April 2009, while unemployment rates persisted at above 9%. Citi analysts admit that the QE program was very important for banks, companies and households, helped them to improve their balance sheets, restore liquidity flows and promoted competitiveness of the US economy (weaker US dollar). But they believe it would be a delusion to expect sustainable recovery of the economy based on success of the QE programs.
Delusion 2: The debt crisis of developed countries was successfully contained
Dynamics of the Greek crisis in May-June suggested that no sustainable political or budget solution was found yet 18 months after the crisis hit, following lengthy political debates, financial support amounting to billions of Euros, and implementation of a few programs of austerity. At the same time, it is a mistake to believe that the debt crisis involves Greece alone or even only peripheral countries of the Eurozone. As estimated by Citi analysts, to decrease US debt to 60% of GDP by 2003, its budget policies should be changed like in Greece. However, budget programs put in place in the US make up less than half of budget programs implemented in Greece (as a percentage of GDP). No doubt, this burden is not as serious for the US because of the US dollar's role as a global currency and the size of the US treasury bonds' market. But, in Citi analysts' opinion, it would be a mistake to believe that the problem of the US debt burden can be resolved without any consequences for economic activity, especially in the year of elections.
Delusion 3: Leading dynamics of US stocks
Over the past couple of months people have talked about the leading dynamics of US stocks and indexes both in absolute terms and as compared with other regions. Indeed, S&P500 has grown since the start of the year in dollars, while MSCI Europe fell 3%. Nevertheless, Citi analysts claim that this leading dynamics was generated by weakness of the American dollar rather than favorable fundamental indicators. Indeed, when allowed for the weak dollar weighted to a basket of currencies of major trading partners, US stocks actually fell 2.6% since early this year. Even more interestingly, S&P500 expressed in the Euro fell 5.1%. This means, with currency factors taken into account, European stocks demonstrated leading dynamics against US stocks. Therefore, it would be a delusion to believe that stock markets can show good results without any support from fundamental indicators, too.
Citi analysts have not revised their expectations of global economic activity and do not consider recession scenarios for 2011-2012. However, it seems to them that investors will have to downgrade their expectations of economic growth in the context of invariably unfavorable economic data and part with excessive delusions which might have shaped investor decisions over recent months.
