A rout in global equities is taking shape with the decline led by Japan and emerging markets. Japan is now in bear market territory, with shares down over 20% from the high. Emerging markets are down 11% on the year. While some are talking about the Fed’s tapering precipitating the fall, the reality is that there are real economy concerns underneath. This downside volatility should have been expected, at least in the US, where I had predicted a major correction in shares sometime this year. My greatest concern, however is in emerging markets. Let me explain why.
When splitting the global economy and markets, one could use four basic groupings: North America, Europe, Japan and Emerging Markets. That does leave out some nuance and some countries like Australia or New Zealand. And it lumps Latin America, Asia and Africa together. But at the macro level, it’s good enough for what I want to say here. When I look at those four economies I see North America in a mild upturn, Europe in a recession that is bottoming, Japan in a brisk upturn of unknown duration, and emerging markets expanding but weakening across the board.
So, you have three areas of the world in stasis or in which second derivatives are improving. By sometime in the second half of this year, I would expect the world economy to be in a moderate upswing all around based on this. However, there are two wrinkles here. First, the emerging markets are decelerating and second, the potential for asset price declines to reverse the boom time is high.
Let’s look at EM first. Equities are way down and warnings have begun on EM corporate bonds. This is a two-fold problem. First, there’s the real economy. I think I have written in the past on how the BRICs are all slowing: China, Russia, Brazil and India are all seeing a major deceleration in growth at the same time. Where this goes is not certain because it depends on policy and it also depends on EM export markets like North America and Europe. If both of these improve, then perhaps EM can recoup some of the lost growth. But my sense here is that this won’t happen without a market hiccup first. And that gets me to the second side of the problem, the risk-on trade. EM has benefitted greatly from risk-on portfolio shifts and these seem to be unwinding. That puts an accelerator to the downside on EM growth as hot money flees. This is why Brazil is removing its forex taxes. We should definitely be concerned here.
Then there’s Japan. I think the bullish picture is on hiatus a bit as the Yen appreciates along with repatriation of Japanese funds and markets digest whether Abenomics has any long-term jazz due to structural reform. When I started talking about Abenomics, what caught my eye was the government’s move to a consolidated balance sheet framework, in which fiscal and monetary policy were fused. I see this as an inevitability given the deflationary background and high government debt. The best outcome for Japan is the post World-War II UK. The UK saw a huge increase in nominal GDP on the back of decent real GDP growth and serious inflation as policy took the UK to full employment and the economy overheated. This reduced the real burden of debt. But as I mentioned in April, the demographics in Japan are all wrong. In the UK, there was full employment and a flood of immigrant labour pushing up nominal GDP. In Japan, you simply don’t have that and this is the sticking point for Japan. Yes, the economy grew 4% in Q1. But can it be sustained without huge government deficits. I am sceptical.
Moreover, the scenario I laid out in December was as follows:
“A bullish scenario for Japan would be currency depreciation down to 100 or 110 yen to the US dollar, moderate real GDP growth and inflation above 0%. This would be a scenario that would be bullish for stocks and moderately bearish for long-dated JGBs due to rising inflation and interest rate expectations. The only policy response that could produce this outcome is one of yet more deficit spending. And remember, this is the (medium-term bullish scenario.
“A bearish scenario for Japan would be continued currency appreciation back to 80 to 85 yen to the US dollar, combined with low or negative real GDP growth and deflation. The toxic combination of deflation and poor growth would imply economic contraction in nominal terms and thus mean that consumer demand continued to sink. The appreciating currency would also cut into export growth and would imply larger government deficits despite the poor growth numbers. This is a scenario that is bearish for stocks and neutral to bullish for JGBs.”
We had the bullish scenario up until April or May but the Yen has been appreciating again and the scenario has become bearish. There is a certain circularity here as Japanese fund repatriation is fuelling the rise in the Yen and covering of short yen trades are making this worse. But then there is also the uncertainty about Abenomics effectiveness to produce nominal GDP and inflation over the medium-term. Which trend is affecting which outcome? I don’t know and it’s very hard to say. But it doesn’t look good right now and will be tough sledding until Japan comes out with it’s next GDP and inflation numbers. If show Abenomics as a success, maybe we will see a renewed boost in shares and a decline in the Yen. But both of these moves had been excessive. None of this affects JGBs, where I think yields will remain low.
In Europe, the second derivatives are showing a slowing recession, which I believe presages a recovery sometime in the second half of 2013. This reminds me a lot of the US recovery in 2009 when I was saying it would happen and getting a chorus of bearish feedback. I see a lot of cognitive bias in this – confirmation bias and recency effect for sure – just as I did in 2009. My view here is that in countries like Spain and Greece, the debt deflation has largely run its course. The downturn will attenuate. What you need for this to work and turn to recovery is a catalyst as we had in the US. If you recall, the catalyst was NOT stress tests and bank recaps, both of which came much later. It was an accounting rule dodge and increased bank earnings. I called this US recovery, the fake recovery because it was based on a bunch of factors which are unsustainable. And I anticipated it would end sometime this year. However, it has legs and I may be proved wrong.
So, Europe’s turning to back-loaded austerity and considering direct bank recaps – even retroactive recaps – is a clear bullish sign in my book. It says that policy has turned less restrictive and that means growth can resume. Ireland will continue growth if the rest of Europe can pull out of its funk. And the core countries outside of France, Italy and the Netherlands should do ok as well. The real problems are in France, the Netherlands and Italy because these are three economies that are large that do not have anything pushing them forward. The Netherlands is in a housing slump. France is also seeing housing detract from potential growth. And Italy simply has no engine for growth. I see the country as a European version of Japan with its horrible demographics and lack of structural reform.
In North America, the talk is of tapering and the markets are in a tissy. It shows you that QE is really about risk-on risk-off and the markets are moving to risk off because they don’t believe in the Bernanke put anymore. In the real economy, it’s stall speed and I expect it to stay that way until Q4, when the next year of fiscal cuts come. The Republicans are now ready to make serious cuts to defense. Someone I know who does budgeting at Defense told me no one made any real cuts this year because they had budget headroom. The real cuts are coming in FY 2014. I think FY 2014 is going to be ugly.
So when I run through all of these different areas, the scenario in EM is the one I am most concerned about now. I see strong recovery in Japan, moderate recovery in North America, renewed recovery in Europe in late 2013. In EM, that’s where the outlier is. And if the central-bank fuelled asset-market boom comes unstuck, particularly in emerging markets, high yield and leveraged loans, we are going to see a lot of carnage in all markets. That could definitely create exogenous shocks. To be continued