Well ─ that wasn't much fun. Chinese equities peaked on June 12, the starting point for the chart above, and clearly their performance has done no one any favors since. If the pain in stock markets was not enough, for instance in Russia, currency movements ensured that U.S. equity investors were penalized for their investments almost anywhere they went ─ surely this must be the first time ever that Bombay was a safe haven. Some of these equity and/or currency markets probably did not need much encouragement from China to perform poorly, but Chinese developments doubtless greased their skids. Elsewhere, China has to be regarded as primarily responsible for the markets' collapse.
An uptick in the euro as a result of the "resolution" of Greek problems flattered European performance early in the period shown. Later, the euro, the U.S. dollar and Pound Sterling attracted capital fleeing virtually every other currency. The Swiss Franc did as well, beginning in mid-August, but not enough to offset earlier weakness. Given their heavy reliance on Chinese demand, Japan and South Korea had held up surprisingly well on both the currency and stock market fronts, until their psychotic North Korean neighbor (with at least tacit Chinese approval) raised military tensions.
British shares suffered from currency strength until August 26, when the Bank of England made it clear that it would not raise rates any time soon, as well as the heavy concentration of E&P and mining stocks in the FTSE 100. Other than Britain, Germany was once again the worst performing major industrial country in local currency terms, as it usually is in a crisis. Some of this has to do with Germany's inability or unwillingness to generate domestic demand, and consequent reliance on exports and the negative effect its currency's status as a safe haven has on exports. But a more important cause is its poorly developed domestic equity culture: a country so viscerally antipathetic to risk cannot handle this sort of turmoil with equanimity. Recently, China has been a good market for German exports, but that is unlikely to continue. The Bundesbank's optimistic August 17 statement seems like whistling in the dark: Germany will almost certainly give back hard-won Asian market share to Japan and Korea.
A market rout is never welcome, but this one will doubtless have the added disadvantage of further prolonging the "will they/won't they" debate about Fed tightening. This has long since become irritatingly, even neurotically obsessive ─ which should probably be taken as a reminder that, as disturbing as it sounds, very few professional market participants have ever experienced an instance of the Fed attempting to impose monetary discipline. Surely markets had discounted any September move several times over, well before this recent selloff. The Fed can do nothing for China, nor can it dissuade Chinese authorities from any course of action they might choose, regardless of the effect it might have on their trading partners. Nor can any Fed action bolster resource currencies such as the Mexican Peso, the Canadian or the Australian Dollar. For all that $-denominated emerging market debt is a concern, the currency movements that have already occurred in the absence of any Fed activity are surely more cause for alarm than a quarter-point increase in Fed Funds would be. Further, many of these borrowers are commodity producers: while commodity price weakness is not helpful to them, their revenues continue to be in U.S. dollars, while many of their costs are in their depreciated local currencies.
The performance of the currencies of America's other major industrial trading partners suggests that, where Fed action might have caused further deterioration of U.S. competitiveness, there are reasonably firm grounds for hope that it will not. While the increase in the trade-weighted dollar over this period is not welcome to American exporters, it is not crippling:
A Fed tightening in September would probably be seen as a vote of confidence in the U.S. economy, and by giving a much-delayed signal that Fed policy actually has a direction might, paradoxically, prove to be a stabilizer for world markets. A small increase in interest rates is certainly supported by the July durable goods data and the striking upward revision for June, as well as the consumer confidence, new home sales and jobless claims reports, and the upward revision to the Q2 GDP estimate. It is noticeable that, when NY Fed President William Dudley commented that perhaps international developments would restrain the Fed from acting in September, equities initially sold off. Unless the markets continue to be in severe turmoil, the Fed would be best advised to go ahead with a modest increase next month.
The Fed need not worry about financial contagion from China. There is certainly a worry about a shortfall in demand for both raw materials and durable goods resulting from slower Chinese growth. But the insularity of Chinese financial markets and the limited penetration of Chinese financial institutions overseas mean that any threat to the Chinese financial system as a result of the crisis there will have limited effect on financial institutions elsewhere. In fact, it may force a liberalization of Chinese financial markets that the U.S. has been pursuing for many years.
There is nothing like a correction to draw bargain hunters back into the market ─ provided there is still capital in reserve. Equity investors in the U.S. and to some extent in Europe have been increasingly cautious about valuations all summer, suggesting that they have build some dry powder, and we know that there are record amounts of uncommitted private equity capital as well as a strong propensity toward M&A among potential trade buyers. The flow of supply into the market is likely to pause, at least for a month or so ─ one can only pity any company that attempted an IPO over the last week. And attractive alternatives to equity investments remain hard to find: even after a modest Fed tightening, the balance of risk will hardly be favorable to bonds. Commodities? Not likely: recent turmoil has, predictably, spurred interest in gold, but that was from a depressed level that it is likely to seek again if equity and currency markets calm. Strength in other commodities is likely to prove elusive for at least six months. Real estate? Commercial property prices have begun to look rather frothy recently.
An investment community that is drawn unwillingly and skeptically into equities is perhaps exactly what the market needs. Fundamental stock-picking as opposed to use of equities as an undifferentiated risk proxy would probably be able to build a base for stronger year-end prices, in a way that recent trading-oriented investor behavior would not. Some of the recent difficulties connected with unwinding ETF positions may cause traders to think twice about using these instruments so enthusiastically as a means to trade in and out of exposure. Before the China crisis erupted, there was evidence from the CBOE correlation index that U.S. markets were headed in this direction ─ that is, that correlation among the components of the S&P 500 was decreasing, suggesting that selectivity was becoming more important to outperformance ─ and improved valuations are likely to attract the sorts of investors whose value-added comes from stock-picking rather than "risk-on/risk-off" trading.
Apart from a somewhat increased interest in U.S. stocks as a result of improved valuations against an apparently robust economic background, I remain positive on Japan, Spain and European small- to mid-caps, as I have indicated in previous articles. U.S. investors can access most of the more familiar Japanese blue chips through ADRs, or though ETFs such as iShares MSCI Japan (NYSEARCA:HEWJ). For most American investors, ETFs are the way to go for Spain and European small-caps: iShares MSCI Spain Capped (NYSEARCA:EWP) and iShares MSCI Europe Small Cap ETF (NASDAQ:IEUS) are the most liquid.
I am less enthusiastic about emerging markets than I had been even quite recently, because I think it will take some time to clear away the rubble. But I still believe that judicious exposures in industrially-oriented economies such as Poland's (accessible via ETFs EPOL and PLND) will be repaid in an acceptable timeframe. It is probably too soon to extend that recommendation to Taiwan or South Korea, but the opportunity to buy in those countries is probably not too far distant: their competitive positions have been significantly enhanced, their equity valuations have become much more attractive and while China may be slowing, it has by no means ground to a halt. These countries will gain business even in a relatively weakened China, and offer significant potential in the longer term.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.