This week stock markets were riled by two different developments:
Changed views about Fed tapering of asset buying (QE)
Disappointing data out of China and disappointing growth in the world economy
So we have US economic strength, leading to an earlier tapering of QE, combined with weaker growth in the world economy. Unfortunately, if turns out to be a trend, rather than an, albeit violent, reaction to some data points that disappointed the markets, this will constitute a rather bleak scenario for stocks for some time.
Considering the rather violent reaction on Wednesday and Thursday, Ben Bernanke seems to have confirmed fears that were already widespread in the market that a tapering of QE is near. Although we think that any tapering, let alone stopping or even reversing the asset buying program of the Fed is very much conditional on future data, it doesn't seem to matter what we think the markets sold off pretty violently.
That could just be temporary, but it should be noticed that many interest rate instruments already began to sell off way before Bernanke's speech. US 10 year bond yields were already well above 2%, from a low of 1.5%. Mortgage rates have increased. Many commodities are sliding and emerging market assets have sold off pretty steeply for some time already.
But, if the present trend of economic data continues in the US, tapering could begin later this year and QE could be completely stopped by mid next year. This is conditional on the economic trends, but these could well be benign. At present, there is a fair amount of fiscal drag operating in the US economy, that is, the public sector (due to tax rises and spending cuts) is detracting from demand, not adding to it.
When the fiscal drag (due to the sequester) declines in importance, economic growth could even increase a notch, increasing the likelihood of QE ending sooner rather than later. The Fed funds rate isn't likely to increase anytime soon, as that is conditional upon unemployment falling below 6.5% and inflation staying calm, but even that could come into the investor horizon after a few good data points.
Less expansionary monetary policy, even if growth picks up a notch, usually constitutes considerable headwind for stocks, especially where these have been on quite a tear already. But there is another possible headwind.
In a world in which is getting a bit 'multipolar' in terms of economic centers and therefore depends less on the US for pulling the world economy forward, faster growth in the US (if that indeed materializes) could well be more than offset by slower growth elsewhere. Here is what the IMF argued at the beginnings of June:
International Monetary Fund managing director Christine Lagarde has warned the global economy may be slowing more sharply than predicted a month ago. (Business Spectator)
And indeed, growth forecasts where slashed for individual countries as well, like China, and economic growth forecast was halved for Germany. But that's peanuts compared to what is happening in emerging markets right now.
Here is what's happening to emerging market currencies:
And this is only until the end of May, June hasn't exactly been more friendly to these currencies. Emerging market bonds and stocks have seen similar sell-offs. The cause? Well, it's simply the expectation of the beginnings of a global liquidity retrenchment. Contrary to before 2007, when capital flows went to emerging markets to take advantage of genuine economic growth, after Lehman the capital inflows are mostly driven by other factors:
Money has been "pushed out" of the W est by QE in the US and Britain, or by the emergency stimulus in Europe, with liquidity washing through the global system.
It is of "inferior quality," "fickle," and likely to be "fully reversed" as the Fed hoovers up excess money. The timing is in the hands of Bernanke, but the screws are already tightening for some in Asia, Latin America and the Mid-East as commodities deflate.
The cumulative inflow of capital has been 60pc of GDP in Lebanon, 58pc in Bulgaria, 56pc in Hungary, 50pc in Ukraine, 48pc in Poland, 42pc in Chile, 39pc in Romania, 32pc in Malaysia, 28pc in Thailand and 26pc in Turkey, to name a few. It can be good or bad. The devil is in the detail. But the overall level is what you see at cycle peaks. (The Telegraph)
So the expectations of changes in US monetary policy has already played havoc in emerging markets - the US and European financial markets are simply the last to respond to these expectations.
On top of that, there are a number of specific country or area risks compounding the retreat from the "risk-on" trade:
Japan has embarked on a bold policy to get out of i's deflationary rot, but this isn't without risk.
The eurozone depression lingers on, and it's remarkable how countries experiencing true depression like unemployment rates are still relatively stable socially or haven't started to team together to get a bigger grip on the ECB policy or threatening to leave the euro altogether. Not to mention the lack of a banking union and new demands for assistance from Greece and Cyprus.
Compared to the risks in emerging markets, China, Japan, the eurozone and the US seem positively tranquil, yet the one cause that unites these risks (apart from the eurozone crisis) is Fed tightening.
The palace on Dam Square in our native Amsterdam features Atlas carrying the globe on his shoulders. It could be our eyes, but he seemed to resemble Ben Bernanke. Risk is definitely off, for now.