A rare moment and test to come
It’s really a rare occasion to see something like we observed in the markets last week. The rollercoaster nature of the emerging markets is to tend to fluctuate in tandem with the developed markets. This time was a bit different. Emerging markets (whether bonds, equities or currencies) avoided the broad sell-off in U.S. equities, which lost all 2018 gains from an index perspective. Furthermore, it’s too early to call an end to this volatile and shaky environment.
Until the recent sell-off, the U.S. equity market had shown strong performance and was seemingly immune to the slowdown observed in the rest of the world. Seen in the context of higher cost pressures, higher real rates, a reduction in the Fed balance sheet and growing geopolitical risks, the over-performance in the U.S. has been a bit of an abnormality. Part of the explanation is found in Trump’s fiscal policy and the vast equity buyback programs, which have helped push multiples in U.S. equities to record levels ( before the October sell-off ). According to research from Nordea economists, the loss of global cyclical momentum is visible in the October sell-off so far, as cyclical equities have started to under-perform. “Though recent prints from the U.S. economy show little sign of slowing, we expect to see a muddier picture in U.S. equities going forward than the rosy one we have now of high valuations and bottomless optimism, as the US economic momentum will also start to feel the heat from previous Fed hikes and a less benign global momentum,” it said. The U.S. Federal Reserve does not sound as worried about equity market volatility as before and rather blames high valuation and financial excesses. Hence, the “Fed put” looks to be further out of the money, and it will take a sharper downturn in equity prices before they change course. As the labor market is tightening and wages look set to rise further, a fourth rate hike this year will come in December, before the Fed delivers another three hikes next year, economists predicted.
“The markets are about one hike behind the Fed’s median projection of four more rate hikes by year-end 2019,” Ethan Harris, an economist from Bank of America Merill Lynch, based in New York, said. “Our baseline is the same as the Fed’s, but we see risks to the upside given that GDP should grow at about 3 percent this year, the unemployment rate is below 4 percent and inflation is at the 2 percent target. Regarding the weakness in the equity market, we do not think the sell-off is large enough yet to make the Fed change course.”
Steve Barrow, strategist from Standard Bank based in London, added: “If the Fed is both starting to fall behind the curve and in the firing line from the White House for any rate hikes it makes, the bottom line is that this years’ financial market tensions might have seemed like a consequence of the Fed doing its worst but, in all likelihood, the worst is still to come and that leaves us somewhat bearish.”