Never do on Monday what you wish you’d done on Friday
The first rule of bear markets is never to do on Monday what you wish you had done on Friday. During bear markets, the constant stream of negative stories from the media leads to a build-up of anxiety among investors, anxiety that pours out first thing on Monday morning on trading floors everywhere.
Beyond doubt last weekend delivered its fair share of stomach-knotting news: from the shocking, and depressingly familiar, terrorist attack in Florida, to the surge in UK opinion polls in favour of a Brexit vote (perhaps reminiscent of 2014’s pre-referendum surge in favour of Scottish independence or something deeper?), to the new lows in OECD government bond yields, to the confirmation that two of the least popular people in the US are now heading the presidential tickets for the Democrats and Republicans, to the growing realisation that China is becoming ever more assertive in its greater neighborhood. In short, there are plenty of reasons to explain why, all of sudden, European and Japanese equities are both down -7% in local currency terms for the month to date. So what investment conclusions should we draw from this latest market hiccup?
The first observation is that bank stocks in Japan and Europe are leading the markets lower. This is troubling, as the relative performance of bank shares has generally been an important leading indicator of broader financial health. Simply put, for a bull market to have legs, the banks usually need to participate in the party. Unfortunately today, either by mistake or by design, policymakers seem to be slowly walking banks either towards irrelevance, or alternatively nationalisation.
The second observation is how quiet the foreign exchange markets have been in the face of this latest sell-off. Following the global financial crisis, the Pavlovian reflex of markets was to bid up the US dollar whenever global risk assets moved into “risk-off” mode. In recent months, this “weak equitiesstrong US dollar” relationship has broken down. Even cable, which arguably should have suffered as heavily as global equity markets in recent days, has held up relatively well. This inability of the US dollar to push on a stream of bad news reinforces my core belief that the US dollar has done rising.
Which brings me to the third observation, namely the 10%-plus year-to-date outperformance of emerging markets against MSCI EAFE, and the fact that in the recent sell-off, emerging markets have broadly held their own. To most investors, this seems unusual; after all, over the past five years, not only have emerging markets been dogs, they have been volatile dogs to boot. In a typical market “risk-off” period, one expects emerging markets to fall more than others. However, so far in June, this does not seem to be happening.
Take Asia as an example: in US dollar terms, Korea, Taiwan, Indonesia, Thailand, Singapore and Malaysia are all up, while India, Hong Kong and Chinese H-shares are down less than -1.5%.
Behind this relative stability of emerging markets lie four realities. 1) The US dollar’s failure to break out to new highs is great news for emerging markets. 2) Emerging markets, unlike developed markets, are benefiting powerfully from falling long term domestic interest rates. 3) Unlike in developed markets, in emerging markets risk premiums tend to be on the high side of their historical ranges. 4) Fiscal easing, notably in China but also in India, the Philippines, Indonesia and Argentina, bodes well for earnings. What market does not like the combination of easier monetary and fiscal policies?
This last point brings me to the final question facing equity investors. On the one hand everything seems to favor an overweight position in Asian equities: attractive valuations, easier monetary and fiscal policies, a broad lack of political uncertainty, a US dollar that is no longer rising, and very conservative foreign investor positioning.
On the other hand, the highly cyclical nature of Asian earnings means that regional markets have historically fared poorly in periods of weak US market performance, and even worse in periods of weak OECD economic growth. Hence today’s quandary: can US, European and Japanese equity markets withstand uncertain domestic political environments, meek global growth and stretched valuations, thereby allowing a bull market to unfold elsewhere, notably in Asia? It happened in 2003, and perhaps the recent market moves indicate that we are set for a repeat of such Asian outperformance. After all, the valuation gap between Asian and Western markets today stands mighty close to 2003 levels.