Volatility will remain high but easing of risk aversion may boost Korean stocks

By Kim Jae-kyoung

Over the past month, global financial markets have been heavily swayed by news and rumors surrounding the Eurozone. European leaders have been putting their heads together but the situation has been deteriorating rather than improving.

On Thursday, they reached an agreement in principle to work together but failed to come up with tangible and effective solutions to contain the debt crisis, which originated from Greece but is now showing signs of spreading throughout the entire continent.

With the debt fear in Europe sending a financial malaise throughout the world, market uncertainties are growing across the globe, dampening investors’ confidence. Although markets are recovering at a slow pace, it is still unclear what the future course will be.

A noted global economist and investment strategist said that in order to address the fundamental problem in Europe and build confidence in markets, global leaders should find a workable solution.

“The Eurozone debt crisis continues to deepen with growing concerns of a Greek default, contagion to other markets and risk of Eurozone’s Lehman moment materializing,” John Praveen, managing director and chief investment strategist of Prudential International Investments Advisors said in an interview with Business Focus.

“Plans to enlarge the European Financial Stability Facility (EFSF), which was part of the July 21 EU/ECB/IMF agreement, is going through a tedious process, requiring unanimous ratification by all of the 17 Eurozone members.”

He pointed out that Eurozone policymakers and central banks’ efforts to minimize the fallout from a potential Greek default have come to no fruition yet. “While Eurozone policymakers are working to develop these mechanisms and safeguards, they are yet to come up with a game changer yet,” Praveen said.

Nevertheless, the veteran economist, who has more than 25 years of experience on Wall Street and the academic world, remains upbeat about the global financial market toward the year-end but stressed that there are three prerequisites in order to clear away market uncertainties.

“Attractive valuations, abundant liquidity and additional stimulus, and easing of recession fears with continued improvement in economic data could potentially fuel a rally in the fourth quarter after the third-quarter meltdown,” he said.

“However, for an equity rally to materialize, markets need to see Eurozone policymakers taking concrete steps to ― 1) ring-fence Greece, 2) prevent contagion, and 3) recapitalize Eurozone banks. Until they come up with a game changer to contain the Eurozone crisis, stocks are likely to struggle and volatility will remain high.”

According to him, following the sharp market decline in the third quarter, global equity valuations have improved significantly and most markets at trading at P/E (price-to-earnings) levels last seen in March 2009, at the bottom of the last market crash.

Outlook for Korean market

Praveen forecast that the Korean stock market (KOSPI) will see a rebound in the coming quarters, with global investors returning to an appetite for risks.

“In the coming months we expect risk aversion to ease and global stocks to post a rally. We expect Korean stocks to rally along with other global markets. Valuations have become very attractive due to the sharp decline posted year to date,” he said.

“Further, the domestic demand remains solid and GDP growth is likely to be around 4 percent in coming quarters. Earnings outlook for full year 2011 remains solid around 12 percent,” he added. “Easing of risk aversion is likely to provide a strong boost to Korean stocks in coming months.”

The Korean financial market on Praveen’s words has been vulnerable to external shocks due to the export linkage of Korea with U.S. and other developed economies. “In order to minimize the external shocks, the country should further improve domestic demand by rising infrastructure and business investment spending as well as further encouraging growth in domestic consumption,” he said.

Status of U.S. dollar

Among global economists and investors, one of the biggest questions at this moment may be how long the U.S. dollar will keep its status as a key currency. Some argue that the greenback will lose its status sooner or later as a result of over-issuance of dollars to keep the U.S. economy afloat..

Praveen, who recently visited Seoul to participate in an economic forum, said that there will be a move to diversify away from the U.S. dollar but it is unlikely that it will lose its status as the most-traded international currency.

According to the former economics and finance professor, in the near-term, the U.S. dollar is expected to remain strong on safe haven demand due to heightened fear and uncertainty in global financial markets despite concerns about U.S. GDP growth outlook.

“In the longer-term, the U.S. dollar is likely to weaken as risk aversion declines. There are few alternatives with the necessary safe haven status and the depth of financial markets as the U.S. The euro which was previously considered as a potential alternative for the dollar is now expected to remain weak until the European sovereign debt crisis is fully resolved,” he said.

“The U.S. is likely to take steps to address the high debt and deficit issues in the medium term. While, over a period of time, investors will start to diversify more broadly among different currencies given the strong growth in emerging economies, it is unlikely that the U.S. dollar will cease to be a key currency in global financial markets.”

Another big debate is whether or not the global economy will undergo a stagflation, a deadly cocktail of stagnant growth and rising inflation ― a period of slow economic growth and high unemployment with rising prices.

Fears of stagflation has been growing globally with the U.S. economy headed down with China’s inflation firming up but Praveen dismisses such concerns, indicating that the trend is now showing signs of turning around.

“Stagflation is possible, but a low probability scenario. The U.S. economy remains on track to a modest GDP rebound in the third quarter driven by consumer and investment spending, despite fears of the slowdown/recession,” he said.

He forecast that the U.S.’ GDP is tracking around 2.5 percent in the third quarter, up from the anemic 1.3 percent growth in the second quarter, and that it is expected to grow around 2.5 percent in the fourth quarter.

“Looking beyond into 2012, the U.S. economy should grow in the 2.5 percent to 3 percent range with support from low interest rates and liquidity. So the U.S. economy is expected to grow at a below-trend pace, but stagnation is unlikely,” he said.

“We expect China to achieve a soft landing with domestic demand holding up well, offsetting the slowdown in trade, he added, expecting China to grow around 9 percent in 2012.

Gravity of power moving

Praveen said that following a series of financial crises led by the U.S. economy and the Eurozone, the gravity of economic power is slowly moving from the West to the East.

“The gravity of economic power is already shifting with emerging economies expected to post strong GDP growth in the coming years. The U.S., like many of the other developed economies, is likely to grow at a relatively slower pace because of the larger size of the economy,” he said.

“While emerging economies are likely to grow at a stronger pace, linkages between emerging and developed economies via trade, investment and other financial flows are likely to further strengthen in coming years, leading to a scenario where economic power is shared among several countries.”

Who is John Praveen? John Praveen is the managing director and chief investment strategist of Prudential International Investments Advisers. He joined Prudential in 2004. As chief investment strategist, Praveen leads the investment strategy team which undertakes financial market and macroeconomic research and analysis, generates outlook and forecasts, and formulates investment strategy, asset allocation and sector strategy. Praveen has more than 25 years of experience in both the buy-side and sell-side on Wall Street and in the academic world. Prior to joining Prudential Financial, Praveen worked at Credit Suisse Group and Merrill Lynch. Before moving to Wall Street, Praveen was a tenured professor of economics and finance at Montclair State University, New Jersey and professor of finance at New Jersey Institute of Technology. He hold a Ph. D in economics from the University of California, Berkeley.