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Global
market volatility and implications for Pakistan
The health of the global economy is reflected in the resilience of the
world economies to a trebling of oil prices. A benign interest rate
environment,
the steady cost of capital together with ample liquidity has provided
support to the global economic system
By
Farhan Mahmood
The month of
July was an extraordinary one for global financial markets. Across the
globe, stock markets witnessed buying frenzy, experienced escalated levels
of euphoria followed by dramatic declines in price levels as fear and
panic gripped the markets on US sub-prime mortgage concerns. The Dow Jones
hit a record high of 14,000 on 19 July; on 31 July, it was down to 13,212,
a decline of over 5.6 percent. Similarly, as of 31 July, the MSCI World
Free Index was down to 383.6 (a fall of 5.4 percent from its 19 July high
of 405.44).
So far August has not
been any better either and markets have been falling like dominoes.
Although for different reasons, the Karachi Stock Exchange suffered a fall
of 385 points and 166 points on 9 and 10 August respectively. This
cumulative fall of over 551 points or 4 percent was on the back of
widespread speculation about the possibility of imposition of emergency in
the country. After having fallen at one stage to an intra-day low of
12,947 on Thursday, off 617 points, the KSE100 managed to end the trading
day at 13,179.41 on the back of short-covering.
Given the numerous
issues on the national scene (upcoming general elections, election of
president, etc.), there is widespread belief that there is more to come on
the political front and this increased uncertainty will not be healthy for
the equity market. Further weakness can be expected. It is quite
impossible to predict when this carnage will end, when markets will
stabilize or when fundamentals will trump fear. In this paper, I will
offer an objective analysis of the situation and what it means for
Pakistan’s economy.
There is reliable
evidence to lend support to the fact that real economic growth is strong
and robust. The increasing level of globalization, higher productivity
coupled with low costs of production and demand-driven growth across
emerging economies has brought about a paradigm shift, perhaps a
structural one in the economic fundamentals driving the global engine of
growth.
The base case for
investing in global equities remains unchanged. Global economic growth is
robust in a low inflationary environment characterized by rising
productivity and strong corporate balance sheets. The IMF recently
increased its global economic outlook. Earlier the IMF was forecasting 4.9
percent growth; it is now looking at 5.2 percent growth for this year and
5.3 percent for 2008, with minimal risk of inflation. China is likely to
account for half of the world’s growth while emerging economies,
collectively, are expected to grow by 8 percent.
Global equity markets
are trading at a price-earnings multiple of around 15 times on forward
earnings. This does not appear rich by most measures, absolute or
relative. The macroeconomic landscape does not depict a negative scenario
for equities as an asset class. Corporate profitability is at
extraordinarily high levels and is still rising, although at a slower pace
than in recent quarters. The majority of corporations have sufficient cash
flow to finance their capital expenditures.
According to estimates
by UBS, an investment bank, second quarter US earnings are beating
estimates1. The bank has recently revised up its S&P500 quarterly
estimate to USD 24.00 from its earlier estimate of USD 23.65. Emerging
Asia is witnessing a similar story of continued growth and upward
revisions in forecasted earnings.
The health of the global
economy is reflected in the resilience of the world economies to a
trebling of oil prices. A benign interest rate environment, the steady
cost of capital together with ample liquidity has provided support to the
global economic system. Over the past three years, global GDP growth has
been over 5 percent, well above its 30-year average of 3.7 percent.
However, a change in risk aversion levels coupled with concerns about the
potential fallout of increasingly high correlations across international
financial markets. This is being aggravated by potential liquidity
constraints that are creating panic. The nervousness began in February
this year when concerns about the US sub-prime mortgage market first
surfaced. At the time, markets became jittery as well but regained
traction on the back of strong first quarter corporate earnings, robust
economic growth and strong corporate takeover activity.
Now, the contagion is
spreading rapidly and repricing of risk in financial markets is no longer
confined to the US marketplace. It is spreading globally and spilling over
to all asset classes. The US 10-year bond yield has declined from 5.12
percent in mid-July to 4.73 percent currently, reflecting a shift in asset
class from equities to fixed income (as money is diverted into a less
risky investment option).
The fundamental source
of default risk now depressing mortgage-backed securities and related
derivatives is the slump in the US housing market. This risk of default is
spreading across other markets as well; losses have spread from
collateralized debt obligations to other credit markets. The associated
rise in the cost of capital is fuelling concerns of the adverse
consequences for corporate profitability and global growth.
Take the case of global
mergers and acquisitions. The total value of merger and acquisition deals
announced in the first six months of 2007 reached a staggering USD 2,700
billion2. During this period, there were 465 transactions executed worth
over USD 1 billion each. Corporate takeovers have been buoyed by stable
interest rates, strong corporate earnings and consequent healthy balances
sheets, as well as high amounts of liquidity circulating in global
markets. This may be adversely affected.
The potential impact of
this malaise on equities is potentially serious. A substantially higher
cost of debt capital would impair equity valuations while a sustained rise
in the cost of capital could put overall economic growth at risk. It would
also bring to a halt the financing of takeovers and subsequently hurt
private equity firms. However, as long as the return on equity is greater
than the cost of equity, the incentive for corporate leverage is likely to
remain intact and leverage buyouts may continue to materialize, albeit at
a slower pace.
The US Federal Reserve,
European Central Bank and other central banks are of the view that recent
developments in financial markets are a long-overdue rationalization of
risky asset prices. The European Central Bank has injected a whopping USD
130 billion to help stabilize the market while the Bank of Japan has
poured in USD 8 billion. The US markets are now pricing an 80 percent
chance of a Fed rate cut (from 5.25 percent) by the end of this year from
virtually none prior to the crisis.
The implications of
these developments in international financial markets for Pakistan are
twofold. (Here I am not offering an analysis of the impact of ongoing
domestic developments in Pakistan on the stock market.) First, if the
increased volatility continues for a prolonged length of time, and results
in a sustained increase in the cost of capital, this could hurt global GDP
growth. Such a slowdown in economic growth is likely to result in a
softening of oil prices, perhaps by 10-15 percent from current levels as
demand weakens. The resulting reduction in crude oil prices will reduce
Pakistan’s trade deficit and reduce the cost of production for
energy-intensive industry. Such a decline in crude oil will also allow the
government increased flexibility to implement its economic plans and
initiatives.
Second, the recent
widening of credit spreads has been sharp, especially in the high yield
and emerging market segments. This spread widening is also spreading to
other credits and is likely to affect the cost at which Pakistan (as a
Sovereign) and its corporates are able to raise capital internationally,
if required. Apparently, Dana Gas and Ithmaar Bank sukuks in the GCC have
been delayed due to the prevailing weakness. Equity volatility and credit
spreads reflect the pricing of risk across a firm’s capital structure
but, as long as the return on investment continues to be greater than the
cost of borrowing, such transactions will most likely be executed.
Until a few months ago,
there was continued debate about whether the world could decouple from a
slowing US economy. According to Morgan Stanley, an investment bank, the
world economy has decoupled3—and it is one of the most important
features of the global economy this year. In other words, a slowdown in
the US will not necessarily have an adverse impact on the global economy
as emerging economies like China, Russia and India continue to contribute
to world growth.
However, from the
experience of the past few weeks in the financial markets, it appears that
this “decoupling” phenomenon has not yet been widely accepted. It may
take some time before the financial markets and economists agree on this.
Till then and until there is more clarity on the extent of losses related
to the US sub-prime market, heightened volatility may prevail and asset
class risk may continue to rise. It seems unlikely that risk asset prices
will have an imminent recovery.
Ref: UBS Investment
Research. 27 July 2007; Private Equity, The Economist, 7 July 2007; Global
Strategy Bulletin, Morgan Stanley Research, 31 July 2007.
(The opinions expressed
in this article are those of the author himself and do not reflect the
views of the organization he represents.)
1 UBS Investment
Research. 27 July 2007.
2 Private Equity, The
Economist, 7 July 2007.
3 Global Strategy
Bulletin, Morgan Stanley
Research, 31 July 2007.
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