Never do on Monday what you wish you’d done on Fri­day

Financial Mirror (Cyprus) - - FRONT PAGE - By Louis Gave

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.

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