After this week’s falling Institute of Supply Management data, we are seeing increased risk as the Fed further withdraws its ample accommodation, while US growth is not at cruising speed yet.
The resulting uncertainty over the US growth picture has weighed heavily on markets: Since the start of the year, US equities are down 5.8, European equities down 5.2%, emerging market equities down 8% and Japanese equities down 14%. The yield on 10-year US Treasuries has fallen to 2.6% and bullish growth positions in Forex have also come under significant pressure.
Meanwhile, implied volatility, as measured by the VIX has jumped 15% to peaks of 22. These levels were last seen at the end of 2012, when markets confronted the US fiscal cliff.
So what now for equity markets?
Immediate trading patterns will be reliant on US data. Another downside surprise should drive risk further. Investors will be watching the employment data today, to see if there is a confirmation that we are somehow entering a soft patch.
Another factor will be the outcome of the ECB meeting yesterday, amid dovish talk and perhaps a refinancing rate cut, which may drive a small rebound in risk. Whether Draghi will announce the non-sterilisation of ECB’s peripheral bond holdings remains to be seen, but at a minimum, he should state explicitly that persistent low inflation cannot be acceptable by the ECB and we should expect some form of asset purchases by the later stages in the year. However, we may have to wait sometime for such an announcement.
On a mid-term basis, markets will revert to the fundamentals. From this perspective, the scenario that markets seem to be discounting – disappointing growth and the Fed tapering – is unlikely. If there was a genuine growth scare, the Fed would pause tapering and even increase funding again.
More importantly, we continue to hold a constructive view on US growth. US credit revival is alive and well, financial conditions remain extremely relaxed, the energy boom is supporting the economy, the ongoing housing recovery is continuing and all these factors are starting to have a positive multiplier effect on the economy. Also to note is that the federal fiscal drag will gradually fade over the coming quarters.
Overall, while volatility in 2014 is expected to be higher than last year, we are now closer to the end of the current market correction than we are to its beginning. In a way, the current sell-off brings memories of 2010, when we had a significant selloff at the beginning of the year.
Are these EM adjustment pains or a full systemic crisis?
The key culprit behind the rolling EM crises in the 1990s was the pegged exchange rate regime that prevailed in most countries. The first currency crisis to hit was in Mexico in December 1994, when the authorities ran out of reserves to defend the peso peg and the central bank was forced to abandon the peg, resulting in the peso falling over 50%. The country’s foreign debt burden quickly soared and a sovereign default followed. Three years later, a similar crisis swept across Asia and spread to the rest of the EM world, forcing one country after another to abandon the fixed exchange rate regime.
Currently, the risk of a large-scale financial crisis similar to the second half of the 1990s is unlikely, as most EM countries abandoned their fixed exchange rate regimes long ago. The advantage of a floating exchange rate regime is that it allows for instantaneous and continuous adjustments, which can prevent cumulative distortions from culminating into a significant crisis. Meanwhile, EM as a whole has a far improved current account balance than two decades ago. Outside of the “Fragile Five” the rest of the EM countries either have surpluses or negligible deficits.
EM turmoil is ultimately deflationary and should act to keep interest rates and bond yields lower than they would otherwise be. One note to make is that the EM crisis in the 1990s turned out to be a bullish factor for US stocks and bonds.
Could the EM currency turmoil derail US economic recovery? Unlikely. The “Fragile Five” may slump into recession or stagnation, but their combined output is too small to matter for the global economy. Emerging Asia is the key. The recent evidence is that growth in Asia remains very steady. China’s is above 7%, Korea’s growth is stabilising and Japan is doing better.
What about China?
China has problems of an entirely different nature. Its banking system has swelled to a disproportionate size, with a great deal of capital wasted in ill-conceived infrastructure projects, ghost towns and unprofitable investments. Given that investment accounts for 50% of China's GDP, the consolidation of this sector could completely unhinge the country's growth.
China is in the midst of a critical transition. To maintain its long-term growth potential, it is undertaking reforms to allow the market, rather than the state, to determine the price of a range of things, including the price of money. As the authorities sanction further de-regulation of money markets, expect market forces to lead rates somewhat higher. This should not have a major impact on companies attaining traditional bank loans, but it will mean higher debt costs for borrowers dependent on the shadow banking sector, raising the prospect of corporate defaults. The transition process has combined seasonal factors to provoke turbulence in interbank markets.
Ultimately, and more importantly, China has the resources to bail out depositors and recapitalise its banks if necessary. The authorities have reacted recently to the concerns over rising rates by injecting extra liquidity into the market, which has helped reduce short-term stress.
There has been a flight to quality with the benchmark US 10-year Government bond yield falling by just over 40bps reflecting concerns over the US economy. Higher rated investment grade bonds have benefited from the drop in government bond yields, with a rotation into defensive sectors, out of cyclical ones.
EM hard currency debt has been the most negatively affected asset class, with hard currency names falling 1.5% during the past week, and local currency bonds down by 3%.
Do recent market moves warrant a change of tack in asset allocation?
While recent market moves have been significant, they have not altered our house views and so our tactical asset allocation remains unchanged.
We remain constructive on equities and see recent volatility as part of the choppy transition from extreme, reflationary monetary policy and crisis management, to a more 'normal' world of self-sustaining growth and higher rates.
