If a tree falls in a forest and no one is around to hear it, does it make a sound? That age old philosophical question is no easier to answer than the existential riddle of 2012 that if the stock market rises in grim economic times, and few are celebrating, is it a bull market? The U.S. stock market continued its ascent - with the S&P 500 up 14 percent for the year - capping a four-year run that is almost exactly on par with the average for the 10 major bull markets over the past century.
This may be the first bull run without the bulls, in large part because the United States is also four years into the second weakest economic recovery from any recession in a century. With stock trading volumes down 17 percent in 2012, with retail investors pulling more money out of stock funds, and with layoffs still thinning the ranks in the financial industry, the general public was feeling way too worried to be making bullish noises.
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The silent American bull could be a defining trend in 2013, too, because history suggests that the stock market is likely to stay strong for another year. Looking back at the major market rebounds since 1907, the S&P 500 usually rises by about 10 percent in inflation adjusted terms in year five, which we are entering now.The stock market has been outperforming the economy because profit margins are at a 70-year high, as companies work hard to raise productivity, particularly in the manufacturing sector. Manufacturing accounts for 60 percent of the S&P 500's profits but only 14 percent of the U.S. economy and employment. The growing consensus—for another moderately good year in the U.S. stock market—looks reasonable.
By definition surprises come where they are least expected:they are the unlikely scenarios that come to pass. So for a major positive surprise in global stocks this year, we look to Europe, where growth may have nowhere to go but up. Industrial production fell by 20 percent across the euro zone after the crisis hit in 2008, and is now climbing back up. The investor mood is still wary, and stock market prices are strikingly low. Worldwide, the average ratio of stock market value-to-GDP (gross domestic product) is about 80 percent; in peripheral Europe, this ratio is rising but is still as low as 19 percent in Greece and 26 percent in Italy, close to the bottom hit by Asian markets like Indonesia and Thailand during the crisis of 1998. Europe has room to rebound.
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The mood in much of Asia is very different, by some measures more upbeat than ever, a warning sign that a change for the worse could becoming. The latest surveys show that four out of five investors think emerging stock markets will rise in 2013, and most think Asia will be the best performing region. Given recent signs of an economic turnaround in some of the large emerging markets, the optimistic consensus seems reasonable here, too. But given the high level of exuberance we need to be on the lookout for deflating surprises.
One possibility is China, where the consensus forecast is still for GDP growth of 8 percent this year despite the fact that growth slipped below that level in 2012, and the strong case that China can't continue growing so fast because it is now a middle-income country. Even perma-bulls on China are beginning to worry about the sharp rise in cases of spectacular graft and bribery, and incoming leader Xi Jinping has warned that corruption could lead to "the collapse of the party and the country."
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China also has too much money oozing into murky debt products.Total lending has tripled in the last five years, including an explosion of lending through alternative and local channels, many funded by new Wealth Management Products (WMPs). These back channels are very hard to track, so no one can fully quantify the risks. One investment bank calls WMPs the CDOs of China — a reference to collateralized debt obligations, one of the exotic US debt instruments that triggered the global crisis of 2008. That's extreme, but most investors are ignoring the growing systemic risk to the financial network in China.
The mood in the global bond markets is even more complacent,following a year in which retail investors bought $680 billion in bonds worldwide, more than double the level of the previous year and an all-time record. Emerging market bond funds were particularly popular, attracting a staggering 25 percent increase in assets in 2012, based on the widespread perception that emerging markets have become the global anchor of macro stability, with debts and deficits under control. Since 2008, the rating agencies have rewarded responsible governments with 190 debt upgrades—including 189 for emerging nations and just one for a developed nation .
But what investors may be under-appreciating is the decline in the macro stability of some emerging markets. There has been no financial crisis in a major emerging market for 15 years, so no one is on the lookout for one. Most investors expect 2013 to be like 2012. The reality is that some important countries, including India and South Africa, are building sizeable twin deficits in the current account and government spending.
Given the political winds in South Africa, it looks like the bigger risk. With weak foreign reserves and a heavy foreign presence in its stock and bond markets, South Africa is vulnerable to capital flight. The government deficit and the current account deficit are rising, and both now represent more than 5 percent of GDP. Social tension is rising over high unemployment. If South Africa totters, its size could produce a contagion in emerging market bonds. So could a major GDP growth shock in China, because 60 percent of the countries in the global emerging market bond indices are dependent on commodity exports, and China is their biggest customer.
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Let us hope history and the consensus hold, and year five of the market recovery proves uneventful, and profitable. But if you're looking for negative surprises, don't look in the US or Europe. Crises occur when the consensus is too confident, spending and debt too loose, and right now, the early warning signs are gathering in places such as China and South Africa.
The writer is head of emerging markets and global macro at Morgan Stanley Investment Management and the author of the book , Breakout Nations: In Pursuit of the Next Economic Miracles (2012)