The recent bout of volatility in the capital markets owes much to the turmoil seen in the emerging markets. Both emerging market bonds and equities have recently been hammered on the basis of:
Slower growth in China; and
The whispers of Fed "tapering", which caused an unwind of the risk trade in EM bond and equities.
By the end of the week, it appeared that the storm that was battering the markets was abating. Breadth indicators had reached oversold levels and fear levels were starting to recede. Consider this chart of the NYSE New highs - New lows, which fell to levels consistent with the end of past minor corrections and saw a bounce late in the week.
Bill Luby at VIX and More suggested watching DBV, the currency carry trade ETF, as a measure of risk appetite. Look at the five year weekly chart, DBV fell to the bottom of its Bollinger Band, which is an indication of an oversold condition, and mean reverted late in the week. Such mean reversion rallies from oversold are classic buy signals.
The question then becomes one of whether this is just a minor correction of the start of a bigger bearish impulse in stock prices. As I mentioned earlier, the fear of Fed tapering threw a scare into emerging markets, largely because the QE promise of cheap money pushed a lot of "hot money" into EM and the prospect of an unwinding caused the "hot money" to rush for the exits.
The carnage is particularly acute in emerging market equities. The chart below shows the relative performance of emerging market stocks (EEM) to the MSCI All-Country World Index (ACWI). This longer term chart back to 2008 looks rather ugly. EM equities staged a relative rally in the wake of the Lehman Crisis but topped out in 2010 and they have been underperforming global equities ever since. Earlier this year, EEM broke an important relative support level against ACWI and has been plunging ever since. From a technical viewpoint, there is no bottom in sight.
Emerging market bonds, however, tell a different story. I wrote last week that I was worried about the signal from the EM bond market and to watch the relative performance of EM bonds relative to U.S. high yield market for signs of a break (see The bear case for equities). Lo and behold, EM bond prices recovered strongly late in the week, not only against U.S. high yield, but against 7-10 year Treasuries:
At a crossroads: The Fed, China and earnings
Which is giving us a better signal? EM bonds or equities?
My trader's instincts tell me that, in all likelihood, the correction is over. The market saw oversold conditions on a number of indicators and the VIX Index hit levels that saw the end of past corrections. The key "tells" were the reversals in these short-term indicators
On the other hand, nagging doubts remain as the sources of volatility are still intact. First and foremost, has the prospects of Fed tapering heightened market volatility? Tim Duy believes that the September FOMC meeting is the most likely point at which the Fed announces that it would start to pull back on QE and his view is becoming the consensus one. He pointed to the likely trajectory of the unemployment rate as one of the key triggers of when the Fed would start to pull back.
On the other hand, Benn Steil and Dinah Walker indicated how difficult it is for the Fed to project unemployment rates by showing how the forecasts have changed over time and the likely effects on the timing of a change in policy.
Moreover, another debt ceiling fight is looming in September. The Hill reports:
A drawn-out debt ceiling fight in Congress could undermine the jobs growth that is expected later this year.
Economists argue that the nation's economic expansion is poised to accelerate in the fall once it weathers the headwinds of tax hikes and spending cuts.
While I recognize that any Fed action is highly "data dependent", would the FOMC move in the face of such fiscal uncertainties?
In all likelihood, the Fed will probably calm market expectations about "tapering" in its FOMC statement on Wednesday, as signaled by the Jon Hilsenrath article. Nevertheless, sources of volatility remain as the markets are still highly jittery. Bloomberg reports that regardless of what the Fed has or hasn't done, it has managed expectations to such an extent that it has de facto tightened. Just look at the expectations for Fed Funds rates:
China and the EM contagion effect
In addition, the markets will stay jittery as signs of softness in China emerge, which they have as shown by Ed Yardeni's analysis:
The signals from commodity markets, a key indirect forward-looking indicator of Chinese growth, have been mixed. While some key commodities like crude oil have seen prices stabilize and possibly stage upside breakouts...
On the whole, the entire commodity complex remains weak and the downtrend in prices remain intact.
The latest bout of turmoil in emerging market bonds and equities represent a cautionary tale for investors. If the mere whiff of Fed tapering of its QE program is throwing the EM capital markets into a tizzy, what happens if China hard lands if it is unable to successfully navigate its transition from a capital intensive economy to a consumer based economy? The World Bank recently issued a warning on the risks to the Chinese economy (via the BBC):
"The main risk related to China remains the possibility that high investment rates prove unsustainable, provoking a disorderly unwinding and sharp economic slowdown," it warned.
It further added that "should investments prove unprofitable, the servicing of existing loans could become problematic - potentially sparking a sharp uptick in non-performing loans that could require state intervention".
In addition, Fitch has warned that China credit bubble [is] unprecedented in modern world history:
The agency said the scale of credit was so extreme that the country would find it very hard to grow its way out of the excesses as in past episodes, implying tougher times ahead.
"The credit-driven growth model is clearly falling apart. This could feed into a massive over-capacity problem, and potentially into a Japanese-style deflation," said Charlene Chu, the agency's senior director in Beijing.
"There is no transparency in the shadow banking system, and systemic risk is rising. We have no idea who the borrowers are, who the lenders are, and what the quality of assets is, and this undermines signalling," she told The Daily Telegraph.
If China were to slow dramatically, what about the contagion effect? While many global banks can claim that they have little or no direct exposure to China and its shadow banking system, which is a likely source of downside volatility, can the same banks say that they won't be exposed if a Chinese slowdown affects the risk premiums in EM bond and equities? Would these same global banks have the same level of minimal exposure to other EM markets like Poland, Turkey, India, Brazil, Malaysia and Indonesia (just to name a few?)
Sam Ro at Business Insider highlighted a Morgan Stanley research report that showed the history of past EM crises:
He went out to show the effects of the contagion effect on these markets [my emphasis]:
"Most shocks that have created sudden stops in the last 30 years have not been big enough to engulf all of EM, nor did they affect systematically important countries first," write the analysts. "Rather, it was the combination of a shock to a vulnerable economy and contagion that spread the shock to other economies sharing a common characteristic with the economy at the epicenter of the shock."
What about earnings?
As well, the outlook for U.S. equity earnings estimates is a source of uncertainty. Ed Yardeni recently showed that Street estimates for revenues have ticked down, which is bearish:
On the other hand, earnings estimates continue to rise:
Can this be right? The top line estimates are falling but the bottom line estimates are rising? Margins would have to improve. By contrast to Yardeni's analysis, Thomson-Reuters showed that Q2 earnings guidance is the most negative on record:
Most of the negative guidance has been concentrated in the Healthcard, Consumer Discretionary and Technology sectors. We can interpret these readings in one of two ways. The most obvious is, "Wow! Earnings are going to be ugly and stocks are going to get hammered." The more nuanced take is that companies are guiding down expectations so that they can beat Street estimates, so most of the bad news is out already.
I have no idea which is the correct way of interpreting the deluge of negative guidance. Add in the uncertainty of the effects of sequestration, the wobbles last week in consumer confidence offset by the positive surprise in retail sales, you have the ingredients for more uncertainty and volatility.
Is the correction over? I honestly don't know. Last Monday, my Trend Model moved from a "risk-on" reading to "neutral", but my level of confidence in its forecast has fallen because macro uncertainty has risen substantially. We are at a crossroads in terms of market direction. My best forecast is that volatility is likely to continue.
Disclaimer: Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.
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