Equity markets have had a rough ride in the first half of 2011, with virtually all suffering huge losses as sentiment continues its downward trend and equity investors flee from risk assets. Recently, there have been some glimmers of hope, but investor confidence will not be restored until there is renewed belief in global economic growth.

There were a few rays of sunshine in the gloomy equity markets in the third week of August as global stock markets staged a rally. In continental Europe, investor confidence in the market was underpinned by demand for German exporters, while London's FTSE rallied for the second session in a row, with resource stocks leading the way.

Similarly, US shares rallied on the news that the government's list of 'problem' banks had shrunk for the first time since 2008, and as investors speculated that the Federal Reserve would take action to spur economic growth.

It was a welcome reprieve from a first half of 2011 that has seen incredible volatility and investors fleeing from risk assets. As a clear indication of bearish sentiment, gold hit $1900 an ounce for the first time ever. Equity markets have increasingly been gripped by fear as the sovereign crisis intensified in Europe, the US suffered the ignominy of a ratings downgrade, and recovery is tepid or on the verge of stalling in many developed economies.

More bad news

The bad news has seemed endless: a record number of initial public offerings have been cancelled or performed poorly, and virtually all stock markets have suffered huge losses. Between July 8 and August 23, 2011, the S&P 500 index plunged by 17.1%, the Nasdaq Composite by 18.7% and the Dow Jones Industrial Average by 15.2%.

On a single day in August, the FTSE 100 index closed 191.37 points lower at 5392.14, a 3.43% fall that wiped £50bn ($83bn) off the value of the index. In percentage terms, there has not been a larger daily fall since March 30, 2009.

The volatility index, the so-called VIX (now more often called the fear index) has recorded the market yo-yos. On four of five trading days in one week in August, the Dow Jones Industrial Average recorded gains or losses in excess of 400 points. The VIX spiked as high as 48% on August 8 and remained elevated at 45% until mid-August. Even with the global rally under way, by August 23 the VIX had only fallen to 36%, a level consistent with heightened anxiety.

Persistent fears

While some market falls have been in response to sovereign debt fears, underpinning the gloom is the persistent fear that the global economy is losing steam. Research published in August by strategists Michael Biggs and Gareth Evans at Deutsche Bank suggests that market falls could create a feedback loop which reinforces any slowdown.

“At the start of the quarter, our view was that global growth had been hampered in the first half of the year by the spike in oil prices and the events in Japan, and that the economic recovery would regain traction in the second half of 2011 as these shocks unwound,” said Mr Biggs and Mr Evans in the note.

“The risk now is that even if our original view was correct, the recent violent swings in asset prices and the fiscal policy debate in the US and the euro area could hurt sentiment, which could weigh on spending and cause growth to slow or turn negative.”

Slowing growth

The pair's research outlines the potential impact on markets of slowing growth. The level of the Stoxx Europe 600 (on August 11 when the report was published) was consistent with global gross domestic product growth of 2.5% in 2012, US growth of about 1% and a forward price/earnings ratio of 10.4. The Stoxx Europe 600 was down 16% since late July and more than 20% since its peak in January.

“To put this in context, global growth was around these levels during the recession in the early 1990s, the recession in 2001, and the Asia crisis in 1998,” wrote Messrs Biggs and Evans. "If US growth were to fall to 0% in 2012 and the forward price/earnings ratio to just below 9.0, then equities could fall a further 25% from current levels."

Not only would this inflict more pain on equity investors, but it would be disastrous for equity issues that bankers say are standing in line waiting for a window of opportunity.

August's stock market bounce has much to do with the Federal Reserve's annual economic symposium in Jackson Hole, Wyoming. Last year, Federal Reserve chairman Ben Bernanke announced the start of the second quantitative easing programme. Equity markets moved strongly higher thereafter until February this year. The rise in prices indicates that equity markets are anticipating the announcement of a third phase of quantitative easing. Fed watchers think this is unlikely. We will find out on August 28 when the symposium closes, just after The Banker goes to press. 

No bankers are willing to say when the equity market will stabilise or improve, although Messrs Biggs and Evans did see potential upside. "US growth of 2.2% in 2012 should be sufficient for equities to yield low double-digit returns, and the upside is tremendous if US growth returns to the 3.0% level and equities re-rate accordingly."

Companies queuing to issue can be sure of one thing though; when the floodgates open, the market will be crowded and pricing will have to work hard to entice investors. 


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