FALLING FINANCIAL MARKETS August 24, 2015
Eric Lascelles, Chief Economist, RBC Global Asset Management
Equity markets have fallen sharply over the last week, with the S&P 500 entering correction territory, off more than 10% from its peak when markets opened on Monday morning. Canadian equity markets have declined further still, down around 15% at one point today. Meanwhile, major developed-market currencies have mostly appreciated relative to the U.S. dollar, while EM currencies, including currencies of commodity-exporting nations, are almost universally down. Sovereign bond yields are volatile, down below 2.00% in early trading on Monday, while credit spreads are materially wider.
In general, EM assets have been hit harder than the rest. Part of the story is that investors are always inclined to paint EM countries with the same brush. This is probably an exaggerated response, though some is appropriate given the geographic proximity of many to China, and the economic similarities of others. Common EM risks exist with regard to external debt, corporate debt, a strong dollar and the implications of Federal Reserve tightening.
Why are markets down?
There are several reasons why markets have reacted strongly.
• On Friday, China printed the weakest Caixin Flash PMI since 2009, at 47.
• The Chinese normally economy generates around 30% of global growth, and thus changes to Chinese growth do reflect on global growth levels.
• In terms of impulses, a theoretical 1.0% hit to Chinese economic growth subtracts:
– 0.25% from US and EU growth
– 0.4% from EM Asian growth
– 0.5% from Canadian growth
– 0.5% from EM commodity exporter growth
– 0.75% from Japanese growth
• The Chinese economy is also quite geared to commodity prices, including the price of oil.
• Chinese equities have been extraordinarily volatile for several months
• This has a limited direct impact on the rest of the world, but may be spooking confidence
• Chinese credit concerns continue to mount given housing problems
• Non-performing loans to banks are now growing at more than 50% per year.
• Most recently, a Financial Times article indicated that eleven shadow banks have requested a bailout. Without help, a large number of China’s so-called "wealth-management products" would default.
• Subsequent to the initial move lower, markets have been disappointed at the inadequate response from Chinese policymakers. In addition, the ECB is not doing more despite the sharp appreciation of the Euro.
• The S&P 500 was long overdue for a 10%+ correction.
• Market internals had been poor for quite some time, with low market participation.
• Historically, in the year preceding the U.S. presidential election, equities have experienced a median correction of -11% since the 1940s, with the past four cycles in the range of -10% to -19%.
• The S&P 500 had been relatively stronger than the credit market for most of August.
A new bear market or a temporary dip?
The natural question is whether this is a new direction for markets or a temporary dip along the upward path, and there are arguments to be made on both sides.
Bear scenario: markets decline substantially further
• The Shiller P/E ratio argues equities are expensive
• Fed tightening would hurt markets in this fragile state
• Chinese growth is reputed to be worse than it looks, with an overhang of big credit/equity/demand problems
• The pain from low commodity prices may be worse than conventional economic models argue
Base case scenario: markets rebound
• Valuations: While some valuation metrics are stretched, others – such as our fair-value estimates –indicate that markets were trading around fair value before the correction occurred – and are now arguably attractively valued.
• Policymakers: It now appears unlikely that the Fed will tighten rates in September, and may instead proceed gingerly later in year. In addition, Chinese policymakers and ECB are likely to respond constructively.
• Chinese growth is undeniably slowing. However, the trend is not obviously worse than the official numbers indicate. Our Chinese economic activity index is broadly in alignment with the official GDP prints. We have long maintained a below-consensus Chinese growth forecast, so we are not caught off guard by the latest developments. In addition:
• Chinese equity problems are not relevant to the performance of global equity markets.
• Chinese credit problems do matter because of contagion risks, but are resolvable (and are being resolved) by the national government.
• Notwithstanding recent foibles in the Chinese equity space, Chinese policymakers are thought to be more capable than most.
• Global growth: Global PMIs are fine if mediocre, signaling continued global growth. Economic slack is still diminishing in the developed world, and global growth in 2016 should be no worse than in 2015. As such, this is not an economic environment consistent with a sustained market decline.
• Risks: The most obvious contagion risk is to the rest of Asia, but Asian markets are much better fortified than during the Asian financial crisis of the late 1990s.
• Some technical factors:
• The S&P 500 was long overdue for a 10%+ correction.
• Market internals had been poor for quite some time, but are no longer so poor after the correction.
• Historically, in the year preceding the U.S. presidential election, equities have experienced a significant correction. However, it is just as important to understand that the market has always ended the year higher than it started.
• The S&P 500 is now back into alignment with the credit market.
• Sentiment readings are at rock-bottom levels according to put-call metrics and sentiment surveys. This is usually an indicator that markets are oversold.
• The VIX is now inverted, with future volatility expected to be lower than current volatility.
• U.S. stocks have only fallen more quickly three times in the past 55 years, and all were ultimately temporary:
– The crash of 1987.
– LTCM in 1998.
– Debt Ceiling in August 2011
Refreshing our views
• It now appears likely that the Fed will delay tightening, barring a rapid recovery in financial markets.
• Commodity prices are unlikely to recover as quickly and far as we once thought. A slow Chinese economy does have a real impact on this, especially when paired with a stubbornly slow supply response. In turn, it will take longer for inflation to revive around the world. This is another hit to commodity exporters like Canada.
What’s stayed the same:
• We continue to believe that the Chinese economy is slowing.
• We also continue to believe that there are material debt risks in the world – see the recent Economic Compass "Vetting Debt Hot Spots" for further details.
• We remain of the view that the global economy is continuing to expand at a familiar pace relative to the last few years.
• Equity markets were fairly valued before this correction, and are thus enjoying an improved risk-reward proposition after the correction.
Markets appear more likely to rise than fall from here, but timing bottoms is never easy and there are still multiple vying scenarios. At current valuations, this may be a good time for rebalancing portfolios, and it is starting to become an interesting time to explicitly shift allocations given less favourable bond valuations and more favourable equity valuations.
In the meantime, we will continue to watch for several points that could mark turning points:
• Action from Chinese policymakers
• Announcements from the ECB
• The upcoming Jackson Hole conference. While Janet Yellen is not in attendance, the Fed is likely inclined to provide comments that help stabilize markets.
The information contained in this report has been compiled by RBC Global Asset Management Inc. (RBC GAM) from sources believed by it to be reliable, but no representations or warranty, express or implied, are made by RBC GAM, its affiliates or any other person as to its accuracy, completeness or correctness. All opinions and estimates contained in this report constitute RBC GAM’s judgment as of the date of this report, are subject to change without notice and are provided in good faith but without legal responsibility. RBC Funds, and PH&N Funds are offered by RBC GAM and distributed through authorized dealers.
® / ™ Trademark(s) of Royal Bank of Canada. © RBC Global Asset Management Inc. 2015
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