January 29th, 2014 | By Nick SargenI wish to acknowledge the contribution of Zulfi Ali, Fort Washington's emerging market specialist.
Following very strong performance in 2013, global equity markets have sold off by about 4% since the beginning of this year, mainly due to worries about emerging economies. The catalysts for last week's sell-off were currency depreciations in Turkey and Argentina and concerns about a looming slowdown in China.
Economic news in the United States, by comparison, suggest fourth quarter growth was strong — in the range of 3%-4% — while Europe and Japan showed continued improvement. Nonetheless, the respective equity markets have retraced some of the gains at the end of 2013.
Looking ahead, we expect the Federal Reserve will announce an additional $10 billion cutback in its quantitative easing program at this week's FOMC meeting. This could place additional pressures on some emerging economies.
We are monitoring these developments but have not altered our portfolio positioning, as we believe the recent market moves reflect a shift in investor sentiment more than a change in underlying economic fundamentals.
After the U.S. and developed equity markets posted stellar results in 2014, investor sentiment has turned more cautious in the first few weeks of this year mainly because of growing concerns about emerging economies. Last week's developments were particularly noteworthy, as a sequence of events triggered a world-wide sell-off. The week began with Turkey's currency under considerable pressure and was followed by a devaluation of the Argentine peso. The key development that impacted global markets was a report showing China's purchasing manager's index had slowed unexpectedly. This, in turn, added to investor concerns that a policy-induced tightening of credit conditions could reveal problems in the shadow banking system.
These developments occurred against a backdrop in which there has been increased concern about emerging economies since May-June of last year. The catalyst then was the surprise announcement by the Federal Reserve that it was contemplating tapering its quantitative easing program. The announcement culminated in capital outflows from some emerging economies including the so-called "fragile five" consisting of Brazil, India, Indonesia, South Africa and Turkey. Thus, it is possible that investors are worried about another round of currency pressures should the Federal Reserve scale back its bond purchase program at this week's FOMC meeting.
Our assessment is that it is too early to tell whether conditions in emerging economies are deteriorating materially. Some of the news stories accompanying the announcement of China's PMI report suggested the manufacturing sector was contracting because the index fell slightly below the level of 50. However, we believe it is premature to draw a strong conclusion from a single report. That said, we are monitoring how the Chinese authorities try to balance the need to slow overall credit growth with the need to sustain economic growth of 7%-8%.
Another consideration in assessing the current situation is that the United States and other developed economies are performing in-line with expectations. The U.S. economy, if anything, appears to have ended 2013 on an even stronger note than was previously expected, with real GDP growth for Q4 now estimated to be in the range of 3%-4% compared with 2%+ initially. If so, it would imply the U.S. economy grew at an annual rate of more than 3% in the second half of the year. While it is too early to tell whether this momentum carried over into this year, we do not detect any sign of a marked deceleration. Consequently, we still think 2014 could be a breakout year in which real GDP growth reaches 3% for the first time since the Financial Crisis.
Similarly, when we examine data for Japan and Europe, both of those regions appear to be growing in line with expectations. The latest batch of purchasing managers surveys for Europe, for example, continue to show the respective economies are emerging from recession. Japan's economy, moreover, appears to be off to a solid start, although this could prove temporary. The reason: consumer spending has picked up considerably in anticipation of a sales tax increase that becomes effective in April.
The bottom line is that the trends in the developed economies still point toward ongoing improvement, even as uncertainty about the emerging economies has increased.
Against this backdrop it's worthwhile to consider whether the recent pressures on the emerging economies could spawn a bout of contagion such as occurred in the 1990s and the beginning of the last decade. Our take is that most of the emerging economies weathered the 2008-09 Financial Crisis very well because of policy measures they had undertaken previously to reduce budgetary and external imbalances, bring inflation under control and reform their banking systems. The ensuing period of monetary easing in the developed economies provided further wind to EM sails, as capital flowed to regions with higher interest rates. During this period, however, policy makers in many emerging economies became complacent, and in some instances, there was even policy slippage.
The prescription for EM countries, in our view, is for them to undertake the next generation of structural reforms. These include the need to liberalize laws for foreign investors and to make their economies more competitive by passing tax, labor, legal and energy reforms. Also, countries with large current account deficits and/or rising inflation will need to tighten their monetary policies to stem capital flight. Thus, the countries that experienced strains in 2013 — i.e., the so-called "fragile five" — may face renewed pressure as the Fed pares back its quantitative easing program, and the list could grow to include Russia and Ukraine among others. In this regard, it is ironic that emerging market central bankers who previously criticized the Fed's quantitative easing program for inducing large capital inflows are now worried about the consequences that Fed tapering could have in inducing capital outflows.
Beyond this, it is difficult to generalize about emerging economies, as some mature economies such as South Korea, Taiwan and Chile are benefiting from sound macro policies. Others including China, Poland, the Philippines and Mexico, among others, are embarking on economic reforms. Therefore, investors will have to pick and choose carefully when investing in this asset class.
In conclusion, the sell-off in global equity markets so far this year can be traced mainly to growing concerns about the emerging economies. While sentiment has turned negative, it is too early tell whether the problems will spread. The good news is the U.S. and other developed economies are showing signs of improvement. Consequently, we are not altering the positioning of our equity portfolios at this time.
Meanwhile, worries about emerging markets have contributed to a decline in intermediate and long-dated U.S. bond yields. However, we believe the Fed will continue to pare back its purchases of bonds over the course of this year if the economy continues to gain traction. Therefore, we view the recent decline in bond yields as temporary.