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At times like these, avoid those who say they know
During my first week at the Financial Times, I was told by a grizzled old hack that the first rule of journalism was: “Never be ashamed to admit ignorance.” That rule needs to be invoked, as I try to explain world markets of the past month.
We live in a connected world. When different markets on different sides of the world start moving sharply at the same time, assume it is not a coincidence. There is a connection. But what is the direction of causation?
During the past few weeks we have seen: a) sharp falls for emerging market currencies; b) a sell-off in Japanese stocks (along with sell-offs in a swath of emerging markets stocks and bonds); c) a sharp move higher in the yields on US Treasury bonds; and d) a significant drop in the mark-up investors will pay for US index-linked bonds, implying a fall in expected inflation. We might add e) a sharp weakening in the dollar against its biggest trading partners’ currencies, led by the euro.
This is not a coincidence. But is all of this activity because of a) the emerging markets; b) the US economy; c) the latest fragments of information on the future intentions of the Federal Reserve, the US central bank; or d) merely the consequence of markets where particular trades and positions have become overcrowded? To liven things up, none of a) through d) are mutually exclusive – you can choose as many as you like.
The case for EM is as follows. The sell-off in emerging assets is drastic and painful, although not yet of crisis proportions. The JPMorgan EMBI index of government bonds is back to its level of a year ago, while the MSCI index of EM stocks is back where it was last September. Latin American stocks are 30.9 per cent down from their post-crisis peak, and approaching their lowest level since 2009. Their growth has been weak, and their weakening currencies augur a potential debt crisis. JPMorgan’s index of EM foreign exchange has dropped 5.3 per cent in five weeks, and is close to a post-crisis low.
As money flows out of emerging markets, it exports deflation to the rest of the world. This explains falling US inflation break-evens.
But this sits awkwardly with expectations that the Fed will start retreating from its easy monetary policy, while the rise in US Treasury yields, now very pronounced, makes little sense. If people are worried about deflation and want a haven from problems in EM, surely they should buy Treasuries and push their yields down.
What about the US economy? It remains set in a clear if unimpressive recovery. The housing market has bottomed and appears to have established an upward trend; the labour market is stable. Rising bond yields towards a more normal level is a straightforward reaction to this, as is an adjustment in expectations about the Fed. The economy is normalising so markets must do so. No wonder money flows out of EM and back to the US.
Does this explanation work? A stronger-looking economy would justify expectations for the Fed to tighten monetary policy sooner rather than later, which would push up bond yields. But this should strengthen the dollar against its main trading partners, when in fact it has fallen sharply, and raise expectations for inflation, when they have in fact fallen.
The bond market is shifting towards forecasting deflation. Its forecast for 10-year inflation, now 2.07 per cent, only needs to drop to 1.7 per cent before it would hit the levels that triggered the Fed into launching the so-called Operation Twist in 2011, a significant programme to ease policy.
So, can we blame the Fed? Certainly, there is confusion over its intentions, but that is mainly because the economic picture itself is finely balanced, and the Fed is led by the data. The extremity of the moves might show high anxiety about the Fed; it is hard to attribute it to particularly mixed messages from the central bank.
Could everything be down to technical factors? A lot of money poured into the same places at the same time. Once some started to exit, there was a shortage of buyers and so a tumble was no surprise. This argument applies strongly to EM debt, which lacks an active secondary market.
And if central banks in eastern Europe are defending their currencies, by buying euros, this might even explain the dollar’s fall against big currencies such as the euro.
But it remains hard to put all of June’s global market shifts down to technical factors. Many markets look badly overdone; few look gripped by euphoria.
Investing in such circumstances is as hard as it gets. Conditions are almost – but not quite – consistent with a return to normality. They are also almost – but not quite – consistent with the onset of a vintage emerging markets crisis.
In such circumstances, it is best to ignore those who say they know what is going on, admit ignorance and hedge your bets.
John Authers is the US Markets Editor for the Financial Times. He also serves as page editor of FT Wealth and Wealth at the Weekend, the FT’s weekly personal finance pages. His beat includes US and Latin American markets, which include stocks, bonds, commodities, foreign exchange, derivatives, wealth management, stock exchanges, and fund management.
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