I doubt we fully understand why the market's selling off. Rather than jump to a conclusion that will depress portfolio performance even more, the usual course of action is to list the things we know for sure, and separate them from factors we only suspect are affecting markets.
WHAT WE KNOW
It started with tapering. I don't want to get into the argument as to whether tapering caused the emerging markets (EM) selloff, but it's clear that currency weakness for the Fragile Five coincided with post-taper, higher U.S. bond yields.
We can hope that the continuing U.S. bond rally – 10-year yields have fallen more than 10 basis points in the past three sessions – helps EM bond markets and currencies to stabilize. No matter what, though, the higher interest rates adopted by India, Turkey and South Africa will squelch economic growth in those countries for the remainder of the year.
U.S. economic data has been weaker than expected. Monday's ISM survey of manufacturing activity survey was reported almost five full points lower than expected at 51.3. New orders, the most forward looking element of the report, showed a fall from 64.4 to 51.2. The ISM news sent the Citi Economic Surprise Index for the U.S. – which measures data relative to consensus economist expectations - skittering lower.
S&P 500 earnings are still good. With 252 companies having reported quarterly results, year-over-year profit growth is above expectations at 9.5 per cent. Sales growth is consistent with the previous few quarters at 2.3 per cent year over year.
The yen has reversed course. After falling more than 11 per cent in the past 12 months, the yen is now climbing against the U.S. dollar. Why does this matter? The certainty of yen declines following Abenomics had hedge funds borrowing in yen and investing in U.S. dollar assets, likely equities (U.S. bond prices were expected to fall during Fed tapering so equities make more sense).
The hedge finds expected, correctly, that the yen would fall and the loan would be cheaper to repay in U.S.-dollar terms. The yen strength in recent days suggests these two-sided trades are being unwound – the funds are selling the U.S. dollar investments and repaying the yen loans.
WHAT WE DON'T KNOW
When the EM selloff will end. The majority of the carnage in developing-world currencies has been focused on countries with severe current account deficits like India, Turkey and South Africa.
In a previous post, I noted that the Mexican peso – representing a country with a small deficit – is the "line in the sand" for global bond managers. The peso is lower by a significant 1.6 per cent Monday. If it goes into free-fall, then the EM selloff is likely to get worse and last for longer.
How much the weaker loonie will help domestic exporters. My column this week covers Canada's lack of manufacturing competitiveness relative to Mexico as a destination for global investment. A weaker loonie will definitely help a bit, but might not be the saviour some expect.
The extent of China's credit stress. The Middle Kingdom has been kicking the can down the road on bad debts for two to three years. So far the Chinese economy has been largely immune from EM weakness but economic data has uniformly indicated slowing manufacturing activity.
Best-case scenario. Current market volatility is merely a "two steps forward, one step back" adjustment to the Fed's withdrawal from bond markets. The Fragile five stabilize, more-stable emerging market economies regain their equilibrium and return to previous economic growth path. North American markets reward companies able to hit growth targets with higher stock prices.
Worst-case scenario: Credit stress pushes rates higher in China, slowing growth further. The Mexican peso falls hard, opening the door for cratering markets in five countries identified as at risk by economist Noriel Roubini – Thailand, Argentina, Venezuela, Ukraine and Hungary. U.S growth slows further, leaving investors with few options. In this scenario, U.S. Treasuries will rally, as will gold.
Scott Barlow