The global equity markets are in the midst of a major sell-off. Why is this happening? What has changed over the past week and do we need to worry? Let me address these concerns and summarise the variety of factors that we think caused this short term rout in global and local equity markets:
The China Effect
China’s stock market started its sell-off in June and is down 40% from its peak. The Chinese authorities have tried to boost confidence in the Chinese stock market in a number of ways, but nothing seems to have worked. It was clear that their currency was getting stronger, relative to the US Dollar, which is making China’s exports more expensive. That is not good In a slowing economy – so, to make their exports cheaper, they devalued the Chinese Yuan twice in August.
China’s tinkering with markets is of great concern to investors, as government actions to take extraordinary measures normally means that the underlying economy is in bad shape.
The US Rate Effect
It is pretty clear to the market that the US Federal Reserve (the Fed) is ready to raise interest rates for the first time since 2006. The Fed has kept rates low to encourage economic activity, by borrowing cheaply and investing to stimulate the economy. As the US Economy improved over the past few years, it appeared that the Fed was getting ready to raise rates by the September 16-17 Fed meeting. The ‘thought’ of higher interest rates means that debt will become more expensive, harder to service and send a message to consumers to spend less, which potentially affects corporate earnings negatively.
Emerging Market Effect
If China is going soft on economic growth, the concern is that emerging markets are also going to slow down, negatively impacting corporate earnings growth. The massive correction in global commodity prices (for example: the oil price has collapsed by 65% over the past year) also negatively influences some emerging economies, especially those who rely on exporting oil, iron ore, platinum and other commodities to generate income to their underlying economies. In simple terms, it is good for consumers but bad for the producers of these commodities.
The sell-off in the SA Rand is not about SA specific issues. We are part of the developing world and our currency will fluctuate with other emerging currencies, as sentiment dictates. From a purchasing power parity perspective, the Rand is undervalued. Our current account deficit, terms of trade and structural headwinds, in terms of electricity shortage and inflexible labour policies, do not bode well for the Rand to strengthen meaningfully in the short term.
Algorithmic Trading and Margin Call Effect
Let’s define these first!
Algorithmic trading is the process of using computers programmed to follow a defined set of instructions for placing a trade, in order to generate profits at a speed and frequency that is impossible for a human trader. (Source: www.investopedia.com)
Margin is when traders borrow money (from a broker) to purchase securities. A Margin Call is a demand by a broker that an investor deposit cash or securities to cover possible losses.
Market volatility is exacerbated when market levels trigger algorithmic trading and margin calls. This supercharges daily volatility, as seen over the past two days in the S&P 500 as well as the JSE since Thursday.
The Facts are…
US economic growth and retail sales are steady with low inflation and interest rate hikes (if the Fed goes ahead after the current market correction) are likely to be small adjustments. Major global bear markets coincide with US recessions, and the recession risk is low. This sell-off is not preceded by shocking economic news from developed markets like the US and Europe.
China‘s growth is slowing as the economy shifts from manufacturing and investment to services and consumption. This is bad for commodities, but the economy is still growing, albeit at a slower rate.
Europe is looking better after seven years of crisis and recession, supported by aggressive central bank easing.
Emerging markets are under pressure but fundamentals suggest no 1998-style crisis, as many governments have learned from 1998 and have generous reserves to stem the tide of selling emerging market currencies. Some, like China, can afford to cut interest rates even further.
The South African economy is weak, facing gradual rate hikes, tighter fiscal policy, electricity constraints and tumbling commodity prices. The weak Rand acts as a shock absorber for the economy, especially for investors, as most of the earnings of JSE-listed companies come from outside South Africa.
Currency markets will remain volatile and we are surprised to see the US Dollar weaken under, these circumstances. Normally the US Dollar and US Treasuries strengthen in equity market corrections. It is uncanny for currencies where Quantitative Easing is in process, to appreciate in a risk-off environment – as is the case with the Euro and Yen at the moment.
How did we at MitonOptimal react?
We lowered the risk in most of our portfolios and funds in the last quarter and further last week. We will keep you informed on our progress and how we will use opportunities in the new market environment.
We continue to remain focused on our risk management process and will apply tactical asset allocation to benefit, when investors overreact to events or fundamentals change. We do not perceive a risk of a global recession based on current economic news in the developed world.
There is too much stimulus in the world economy (China/India cutting rates, Japan and the European Central Bank providing QE) to counter the negativity from China and potential US rate hikes. In fact, Europe will need to keep interest rates at rock bottom, near zero, for a while, because of the high levels of debt amongst most governments. Recent events may also put a hold on the US and the UK, causing them to defer interest rate hikes in the near term.
Although it is hard for us to ‘stomach’, we embrace volatility, as it provides opportunity. We remain confident in generating inflation beating returns over the medium to long term.
News Flash: What just happened to the stock market?