North American Portfolio Strategist Martin Roberge questions whether the Fed has handicapped EM central bank. EM economies account for ~50% of the global economy and ~70% of GDP growth. As such, DM economies alone cannot lift global growth expectations while real rates in EM economies appear too high to boost the outlook for EM growth. Martin believes more monetary and fiscal stimulus is needed but unfortunately the Fed may have handicapped EM central banks’ reflation cycle by not collapsing its dot-plot and reiterating its tightening bias at the last FOMC meeting. EM currencies remain under downward pressure and cutting rates while the Fed is expected to raise them may accelerate EM currency depreciation, stir up inflation risk and debt defaults. While Martin’s market-based leading indicators show that the global economy is shifting from deceleration to stabilization, the risk is that EM central banks fall behind the economic curve and another global growth scare occurs. Fortunately, the depreciation of the Chinese yuan and Indian rupee appears orderly while inflation in both countries seems under control. This should allow the PBoC and the RBI to continue delivering monetary and fiscal stimuli hence provide backstops to the world economy and financial markets going forward.
The consensus is that equities are going through a 1998-like fall correction followed by a rally in Q4. We agree. However, Martin does not rule out a more prolonged correction if the US$ does not cooperate. History shows that post-correction market recoveries are usually fueled by US$ weakness. This is not only needed to re-rate EPS growth expectations but to stabilize EM currencies as well. This time around, the Fed is throwing investors a curve by maintaining a tightening bias. Therefore, the onus will be on stronger EM economic data to stabilize EM exchange rates. The bad news is that it could be a lengthy process. The good news is that EM reflation efforts in H1 should lead to EM growth improvement in H2. Otherwise, sub 13,000 and 1,900 levels on the TSX and SPX provide attractive potential returns to Martin’s revised fair values. Also, downside risk has moderated much when one considers that historical market corrections have averaged 14%. Last, at 4.6%, the US equity risk premium is much higher than at the market bottom in 1998 (1.3%). Thus, investors should not get more bearish upon a re-test of August lows, a point around which Martin intends to boost equity exposure.
Martin notes that not all tightening cycles are alike. One thing that has not changed in the Fed’s rhetoric is that the next tightening cycle will be gradual (like in 1986-87) rather than mechanical (like in 1994, 1999 and 2004). So, if history is any guide, sectors expected to lead the market going into and after the first Fed hike should be those that have been beaten down the most through the Fed’s “expectation” phase. This also implies a rotation from momentum to value and from defensives to cyclicals. A weekly close in oil price above its 13-week average (~$46/bbl) along with a weekly close of the DXY below its 40-week average (~96) would support this rotation.
Martin reflects on the equity markets that been in a repair mode and this morning’s dismal US job and factory orders’ reports mean that more fine tuning will be needed for investors’ risk appetite to return. Another item at the repair shop is the Fed’s credibility. Several FOMC members paraded this week pushing for a rate hike this year. But the possibility for an October raise expressed by the Richmond Fed President yesterday just shows how enigmatic (if not broken) is the Fed’s reaction function. One central bank whose governor seems to have both hands on the wheel is India’s RBI, which delivered a bigger-than-expected 50bps rate cut. Interestingly, several EM currencies appreciated following the RBI decision. This may be an early indication that other EM central bankers should not fear monetary relaxation which is much needed to boost EM and global growth. The good news is that the combination of: 1) the drop in US 10-year bond yields below the 2% handle, 2) the US$ or DXY crack below its 200-day average, and 3) heightened US debt ceiling issues flagged by US Treasury Secretary Lew suggest that the Fed is sidelined for a while (Q2/16, according to Fed futures), hence removing a key headwind to EM reflation. As Martin pointed out in the October edition of the Quantitative Strategist, EM currency and EM bond yield stability is paramount for stock markets to successfully re-test August lows and allow risk assets to resume their uptrend. This dynamic has been observed this week but as the old saying goes, “one week does not make a trend”. Thus, investors should not complain too much if this week’s drop in the US$ were to persist for longer.
The Canadian GDP rose for a second month in July (+0.3% MoM), perhaps signaling the end of the recession. But the RBC mfg. PMI (48.6 in September) tells a different story when the decline of the past three months is considered. Otherwise, all eyes were on statistics of the US, our principal trade partner. As Martin’s Chart of the Week shows, the window for a Fed rate hike is closing rapidly. Indeed, nonfarm payrolls (+142k) missed expectations (+201k) by a wide margin while the BLS released downside revisions for both July and August (-59k in total). Wage inflation remained flat for the month, hardly showing signs of acceleration. Meanwhile, statistics for headline and core PCE inflation settled at 0.3% and 1.3% YoY respectively in August. The ISM also declined to 50.2 in September (from 51.7), just above the boom/bust line. In summary, market expectations for the first Fed hike are getting pushed back to April 2016. Elsewhere, in Europe, although the PMI slightly weakened (52, from 52.3 in August), the Eurozone has slipped back into deflation (-0.1% YoY) on the back of weak August producer prices (-0.8% MoM and 2.6% YoY). Consequently, expectations are for the ECB to increase its support to the economy. Elsewhere, in Japan, retail sales slowed (0.8% YoY, from 1.8%) and industrial production fell 0.5% in August, also prompting calls for increased stimulus. However, BoJ Governor Kuroda so far shut the door to further QE. In China, as expected, the mfg. PMI settled at 47.2 (vs. flash PMI at 47). However, the non-mfg. PMI dropped to 50.5 (from 51.5) and came in below consensus (51.2). Admittedly, Chinese authorities are taking steps (on top of interest rate and RRR cuts) to revive the economy, with the PBoC cutting the minimum down payment for first-time home buyers to 25% (from 30%). But these measures have yet to filter through the economy. Finally, the PMI in India dropped to 51.2 (from 52.3) and validated the RIB 50bps rate cut. Last, August industrial production cratered in Brazil (-9% YoY). This is what happens when fiscal austerity is not offset by some form of stimulus.
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