Saturday, 12 February 2011

The ship that weathered the storm is sinking?

No longer than a month ago I extolled Polish economy for its resilience in the context of the first interest rate hike in the current cycle of monetary tightening, but over the course of last two week I mulled over the issue, took it apart and now I feel like taking back what I wrote then, although I cannot deny I did believe what I wrote was true and reflected my opinions.

What prompted my recent change of heart was a market analysis. I observed the performance of Warsaw Stock Exchange blee chip index (WIG20) and compared it with performance of other major indices (German DAX, US S&P 500, Japaness Nikkei 225). All the foreign indices this year hit their many months' highs repeatedly, whereas Polish WIG20 barely climbed to 2,809 points, peaked there and retreated. Polish stock market's relative performance has been very poor in the last weeks and this seems to be a distrurbing signal.

Stock market performance is one of Leading Economic Indicators, what in simple words means its changes herald changes in the whole economy. It has to be said stock market performance is not unfailing and if "Wall Street predicted nine out of five recessions after WWII", signals it sends might be misleading. But if we look at recent happenings in a broader context, Warsaw Stock Exchange does not have to be wrong this time.

Please note that performance of stock market is correlated not with GDP but with the pace of GDP growth. Economy may contract, but if the contraction is not as deep than in the previous quarter, stock prices should rise. This rule works also the other way round - if economy grows, but not as fast as earlier, stock prices should decline. To be precise, stock market should precede real economy by one or two quarters, although in the recent crisis there was no lag (rebound in 1Q2009 and peak in 3Q2007).

Let's have a look at some facts.

1. A lion's share of the turnover on the Warsaw stock market is generated by foreign investors and speculators. They generally buy the most liquid stocks and therefore their interest focuses on securities that make up the WIG20. Their decisions are generally based on their perceptions of prospects of Polish economy. Buying stocks is actually about buying future, as all present information are already incleded in a price. So if speculators and investors are optimistic about Poland, they buy Polish stocks; when they turn pesimistic, they dispose of Polish securities. If their perception of Poland worsens, it is not because they have it in for Polish stocks, but because something might be amiss with Poland. What is happening now is not a reprise of speculative sell-off of Polish currency and assets from early 2009, when market sentiment was overtly negative, now it has only fallen back.

2. Why? One reason are the proposed changes in the pension system. Regardless of what I think of it (I am in two minds about it, I will try to present a subjective evaluation of those changes before they take effect), the motives behind the government's decision to transfer a part of pension contribution from private-run pension funds to state-run pay-as-you-go social security system are clear. The government did not concede private pension funds are too expensive and too ineffective (as they in fact are!) are did not wish to save poor citizen's pensions from being squandered by greedy fund managers. Polish state gripped that money to curb the increase of outright public debt and swept the problem of its obligations towards future pensioners under the carpet. It does not mean I fully disagree with their decision, but this time a drowing man was desperately trying to catch a straw. The move also reflects upon the pitiful state of Polish public finances and interminable shortage of money in the system, which results from years of mismanagement.

3. What could have scared the investors and speculators away? If the government seizes the money, situation in Poland must be quite bad. Private sector fares well, but if things keep getting worse it will have to bear more and more burdens and so the consumers will. Higher taxes will impinge on lower investments and consumption and thus will hamper GDP growth...

4. Another factor is connected directly with mechanics of capital markets. Pension funds every months have bought stock on the market to their portfolios. After the reform, if they get less money, they will buy fewer stocks, what consequently will weaken the demand side on the market. Without demand from pension funds rates of return on the market will be lower. This assumption could have deterred some market participants.

5. Many economists say the best year in the current business cycle will be 2011. Growth will be stimulated mainly by investments, in a large part financed from EU funds and aimed at EURO 2012 preparation. Poland has reached its limits as a free-rider - it fared well during the crisis, but the current pace of growth is unsustainable without structural reforms.

6. Rising interest rates also might negatively affect the economy, but with inflation as the overriding target, we have no choice, but to accept monetary tightening.

7. Appreciating zloty may harm our exports and contribute to the slowdown in pace of GDP growth. If interest rates disparity increases (quite probably, as in the Eurozone and in the USA interest rates are said to be kept near-zero to sustain the recovery), carry traders will do their job and no central bank interventions will help. Only a shift in market sentiment towards Poland can bring Polish exporters relief.

Neverthelss Polish GDP should be on the rise for the next three years, if only nothing unexpected happens, but we should be prepared that the growth will be sluggish (2% - 3% p.a.) rather than robust. Warsaw stock market might be already discounting these information. In turn German economy proves its perfection - our Western neighbours have turned around their public finances and they proved again their economy stayed competitive. Over the last decades competitiveness was the crucial performance driver. Here we can take leaf out of German's book. On the other hand I would not wish Poland to follow the example of the USA. Their stock market is soaring just becuase the US central bank is carrying out quanitative easing to buoy up US economy, what in simple words means guys from FED are printing money, economy still is in the doldrums and speculators borrow money at 0.25% and drive prices of equities and commodities up.

Paradoxically, even if Poland underperforms in comparison to other countries in the coming years, it may give it a soft landing. Other economies, affected by asset price bubbles (if nothing changes in terms of regulations and monetary policy they are bound to inflate, but not in Poland, Polish economy will suffer from rising food, petrol and gas prices) will go through another, even more severe financial downturn and Poland, if run wisely, might be again the only green country on the economic map of Europe.

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