Sameer Sharma

A bumpy road still lies ahead

 

— Sameer Sharma

 

These days, traders have become quite nervous about anything that even moves under the sun. The need to make profits on a daily basis coupled with a spate of bad news from the old continent have got the dollar to rise again, thereby unwinding an until recently profitable carry trade strategy of being short the dollar and long commodities, emerging markets, developed market equities and high yield bonds. As the Germans, the real power in the European Union, debate on how exactly to get the Greeks out of hot water and more importantly on how to save the viability of this European Union, traders have grown confused as to how to fund their risk taking habits.

 

Temporarily at least, the art of reflation via purposeful monetary policy initiatives has turned back into myth. As the dollar index (DXY) appreciated and breached some key resistance levels over the past two months, markets have fallen because there is no carry trade to push them ahead. Economic recovery or not, it has mainly been the unprecedented sums of liquidity that have been thrown around by world central banks that have pushed asset prices higher.

 

 

Save the Greeks, save the Euro

 

For years, the Greeks have spent much more than they could afford and have benefited from German economic might via cheap interest rates and, as we have learnt recently, exotic swap agreements that they would have never been able to get access to, had they not been in the EU. The Greek economy is nothing to write home about either, productivity itself has remained dismal for years.

 

But the market correction has not only been about the Greeks, for the Greeks may have been important once in world history but not today. We need to understand that the health of countries like Ireland, Portugal, Spain, Italy and a host of other countries in the region is not that great. If Greece is allowed to go under, then many more could follow.

 

We must never forget that “too big to fail” is more politically acceptable for countries than in the case of banks. For now, the geopolitical strategists still feel that the Germans need to be part of something much larger in order to remain important in the century of the BRIC and hence, deals are being made to save the Greeks and prevent any contagion or at least limit them. Germany can afford to bail out Greece but it cannot afford to bail out the rest.

 

If investors are beginning to question the viability of Europe, and since the German economic engine unexpectedly stalled in the 4th quarter of 2009, we cannot expect the European Central Bank to be the first to raise rates this year or the next and nor can we have a world of faith in the Euro. Sadly, it is not that the American economy is in great shape either but as bad as the fundamentals of the dollar may be, they appear to be better than the Euro. The key for investors is again to remain diversified by investing in various currencies or short term bonds of countries with relatively sound fiscal positions.

 

The 21st century will be that of Asia. The American economy has seen its best days but while it is likely to remain the sole superpower for decades to come, it is clear that China and eventually India are beginning to take back their fair share of global economic might. In the pre-industrial revolution era, India and China accounted for close to 40% of the global economy. Where is Europe? It has an ageing population, changing demographics, bar Germany, low productivity growth rates and a more humble future.

 

In that context, that is, the rise of Asia, it has been the talk of the Chinese stimulus pullback that has also played a big role in cooling markets. When it comes to making money, capitalists are not bound by primitive human notions of discrimination, fear or hate based on colour, culture or religion. Even in the US, companies that have an emerging market exposure have been doing better than the rest, for the markets can smell the changing times decades in advance well before others ever will. During the last week of February, the market has been filled with rumours of China stress testing the Yuan, potential Greek bail out formulas, dismal housing data in the US and still weak credit markets especially in the commercial real estate sector, heck enough news to make the markets go nowhere.

 

Rise in interest rate risk

 

Considering the potential downside risks and talk of the double dip recession (resurfacing again), the risk return trade-offs do not bode well for high risk taking. This is why the defender of economic reflation via asset markets, Ben Bernanke, came out this past week and talked about a nascent economic recovery and the need to keep rates low for a long time to come. With the dollar gaining some strength in recent weeks, the export sector in the US which has been living off emerging market resilience and dollar weakness may slow down a bit.

 

The charts are telling me that there are many question marks. The S&P500 has resistance ahead of itself that it needs to work out. The key resistance level of 1150 if breached would signal a price target of 1200-1250 over the next 8 months. We are likely to see a test of that 1150 level in the coming weeks. If we fail to breach it, then we would have a classical double top formation and it would signal the end of our party.

 

Of course, the direction of equities, commodities and gold will depend on the dollar (dollar/euro) whose RSI began to diverge from price chart on 29 January 2010. While RSI divergence typically signals a topping process, there is no signal on the length of time it will take for a top to form. It would hence be better not to add more dollars in the portfolio but to remain neutral.

 

Diversification remains key. Seek out other currency pairs and protect your wealth should be the mantra of 2010. Once the dollar tops out against the euro, this will be a good signal to take on some more risk not necessarily in equities but in high yield corporate bonds, provided you have done a great research on your company.

 

The risk return tradeoffs of high yield corporate bonds versus equities is attractive right now. There is a major refinancing requirement for near junk and junk rated companies over the next three years to the tune of 1.3 trillion dollars. There is great opportunity in the high yield bond market although there is nothing but doom and gloom in the long term fundamentals of the Treasury bond market.

 

It is important to hedge that rise in interest rate risk when participating in the bond market. Convertible bonds which when in the money have much lower interest rate risks will be a good bet. Furthermore, high yield spreads have some more room to come down from. In equities, it is better to stick to high dividend yield stocks for now.

 

The Mauritian stock market is going nowhere

 

As Europe has soured investors’ risk sentiment, the Mauritian market too has gone nowhere. Results have been disappointing. Hotels have done poorly but that was to be expected. Bank profit growth look rather tame to nonexistent for this year and as the comments of Promotion and Development’s quarterly report confirm, office demand is not as strong as many hoped.

 

The Mauritian economy will still lag no matter how optimistic some local analysts may be and continued fiscal stimulus, especially in getting the infrastructure projects up to speed is required. The only positive rumour I heard about in a foreign Frontier markets fund commentary was that if Mauritius Telecom lists itself this year, then State Bank of Mauritius could benefit from it. I hear about this every year and hence call it just a rumour that never seems to die off.

 

Looking at the technicals, the Stock Exchange of Mauritius continues to trade in a narrow channel of between 1630 and 1745 with heavy resistance at 1750. Should the market break this level with non diverging volume, then we could have an 1822-1850 target in the not too distant future. However, should the market go below the 1630 level on decent volume, we would have 1500-1530 as a potential downside target.

 

From the graph, you can clearly tell that the reverse head and shoulders has ended, and hence this is why we find ourselves in a nary channel formation with three mini tops around the mid 1700s. So what do you do? Nothing, you wait for the above mentioned levels to be breached before you buy or sell.

 

How I pity some of those local fund managers who have taken such large local positions a bit late into the game and find themselves having extremely risky allocations during these uncertain times. They accounted for a large part of the market rally themselves, and now that they are more than fully invested, there is no new money to make the market go higher, especially not when profit growth outlook remains so uncertain. Let us hope that they make full use of the soon to be launched futures market to get back to more realistic asset allocation levels. 

Sameer Sharma is a Canada-based Chartered Alternative Investment Analyst

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