Liquidity cycle promises a bumpier ride for 2011

PUBLISHED : Tuesday, 07 December, 2010, 12:00am
UPDATED : Tuesday, 07 December, 2010, 12:00am

As Asia's investment analysts are struggling amid uncertain conditions to come up with their forecasts for the coming year, many are looking to the past in the hope that history can provide a reliable guide to what 2011 may have in store for the region's markets.

Looking in the rear-view mirror in an attempt to see what lies ahead isn't quite as dumb as it sounds. After all, economies tend to move in cycles, so it makes sense to identify times in the past when we were at a similar phase of the cycle and to ask how markets behaved over the following months.

That's more or less what Sakthi Siva and her team of analysts at Credit Suisse have done, and to them conditions today at the close of 2010 look a lot like they did towards the end of 2004.

Back then, the global economy had emerged from the slowdown which followed the dotcom bust, the 11 September 2001 attacks on New York and the Sars outbreak of 2003. Assisted by fiscal and monetary stimulus and by restocking in the developed world, Asian economies rebounded strongly. And after a shaky start to 2004, Asian stock markets performed well in the second half of the year, rising almost 20 per cent.

As the first chart below shows, that's roughly the trajectory followed by regional stocks in 2010. Just like today, 2004 ended on a nervous note. Then as now the OECD's composite leading indicators had peaked earlier in the year indicating a softening in industrial production (see the second chart). What's more, late in 2004, just as in 2010, China raised interest rates in response to the threat of overheating, leading the world's major economies into a new cycle of monetary tightening.

The result then was what Siva at Credit Suisse calls 'a mid-cycle slowdown'. This time around she is expecting something similar, with activity bottoming in the middle of 2011.

That sounds worrying, but the historical precedent is encouraging. Asian stocks went on to gain 19 per cent in 2005, and Siva expects a similar performance in 2011, with the Hang Seng Index rising 20 per cent over the next year.

Others who follow the lessons of history agree that 2011 should be a promising year for investors, but warn that there will be higher risks ahead.

Fund manager and economist Enzio von Pfeil watches an indicator of the liquidity cycle he calls 'the economic clock'. His clock's dial has four quadrants.

In the first, the economy is in recovery mode. Liquidity is plentiful and demand for goods is subdued, leaving plenty of excess money free to flow into asset markets. Markets perform strongly. In the second quadrant, liquidity remains plentiful but demand for goods picks up, which begins to fuel inflationary pressure. Performance is less impressive. This is the stage Asia has now reached.

In the third quadrant demand for goods outweighs the supply of money, the economy peaks and markets begin to fall. In the fourth money remains tight and there is an excess supply of goods as the economy bottoms out.

According to this framework, with Asia still in the second quadrant conditions remain favourable for investors, but at some point the region will swing from the second into the third segment of the clock and markets will begin to decline.

Other analysts agree that there is more risk ahead, but happily the transition may still be some way in the future. Timothy Moe, portfolio strategist at Goldman Sachs, also follows a four-stage model of the equity cycle where the successive phases are characterised by hope, growth, optimism and despair.

'Hope' is the initial rebound from a bear market. The second stage, 'growth', is driven by expanding earnings. This is where Asia is now.

In the third stage, 'optimism', earnings growth slows down while prices continue to rise. History shows this phase is often short-lived before markets tip over into 'despair' in which earnings contract and prices fall as stocks slip into a bear market.

Moe believes the market may well switch from 'growth' to 'optimism' during 2011. That sounds worrying, but as he points out, the optimistic last phase of a bull market typically offers higher returns than any other except the initial 'hope' stage of the cycle. As a result, he expects some handsome gains in regional markets next year, with the Hang Seng climbing by around 25 per cent over 2011.

That all sounds encouraging. But be warned. History teaches us that in stock markets optimism can turn to despair in a very short period of time indeed.