Shrugging off any hint of the summer doldrums, July saw a strong start to the third quarter for global stock markets.
While some investors in Asian and emerging market equities with strong year-to-date numbers may be tempted to book some profits, the reluctance of the market to turn minor dips into corrections suggests there are also investors who missed out on this year’s first-half rally and are waiting to enter the market on any dips.
If markets do cool significantly in August or September, as the US debt ceiling issue approached, it could prove a good buying opportunity, as on a 12-month horizon, EM fundamentals still appear sound.
EM fund flows expected to stay positive
Portfolio inflows into Asian and global EM debt and equity funds have been strong year-to-date, which is hardly surprising in view of the strong rally in these markets. In the first seven months, EM debt (EMD) and global emerging market (GEM) inflows reached US$42 billion in August, with US$30 billion going to passive funds and US$12 billion to active funds.
There is ample scope for the Asian region’s strong fundamentals to continue attracting positive portfolio inflows in the remaining months of 2017. For EM, the long list of positive fundamentals includes firmer currencies and commodity prices; fewer worries over China; improving profit margins; and better capital discipline.
This marks a major turning point in corporate earnings and valuations that compare favorably to developed markets (DM), even if they are no longer cheap in absolute terms.
Strong demand for EM bonds
EM and Asian debt continues to be an asset class experiencing strong, sustained demand. There were positive inflows to all the major EM bond markets in the latest data week (Aug. 2), according to HSBC Global Research’s comprehensive Global Bond Flows Compass, including Thailand, India, Indonesia, South Korea, Mexico and Turkey.
We do not agree with the oversimplified view that EMD debt flows are tightly linked to expected US short rate differentials. With inflation low across most of the EM universe, central banks in emerging economies have continued to cut interest rates even as the Federal Reserve gradually tightens policy.
India is the latest example of this – the Reserve Bank of India lowered the repo rate by 25 basis points to 6.0 percent at its July monetary policy meeting.
Global economic momentum is peaking
For now, we continue to take a constructive view of the global economy, since a gradual deceleration in activity appears more likely than a move into recession, where the usual late-cycle pressures and imbalances are almost completely absent.
Looking beyond the second half of 2017 into 2018, one frequently encounters the view that “the US economy is on the cusp of moving from late cycle to downturn”.
While a gradual loss of momentum in 2018 that causes the US economy to ”gently” slip into recession cannot be ruled out, it is not a high probability scenario.
A bigger risk might be a policy mistake from the Fed. It would surely be ironic if the Fed in its eagerness to build an interest rate cushion before the next recession were to trigger that recession by raising rates too quickly.
We believe that the Fed understands, though, so the risk of a major policy mistake is low.
A wide variety of surveys – including the latest annual survey of global corporate capex intentions from S&P – suggest private investment is finally starting to improve. This may be enough to keep the global economy on a moderate expansion path in 2018.
Volatility likely caused by event-type risk but recovery phase will soon follow
In the second week of August the war of words between the US and North Korea over the latter’s missile launches caused the Volatility Index (VIX) to spike higher, but only to 16, a level equal to the local peaks that occurred in April and June.
One of investors’ biggest fears is that the current low volatility regime may soon end in tears, with central bank tightening the most likely trigger for the Chicago Board Options Exchange’s VIX of US equity volatility to move higher based on option pricing.
Our view is that while low volatility per se does not equate to investor complacency, the chances of a US market correction occurring within the next 12 months have risen, with the potential to spill over into other markets (including non-US equities, bonds and currencies).
The most likely cause is some event-type risk, with the US Treasury debt negotiations and threat of a Federal government shutdown in October an obvious potential hurdle.
Our expectation would be that a failure to raise the debt ceiling (or any similar catalyst) could produce a normal or run-of-the-mill S&P correction in which the index falls by 10 to 15 percent, which is soon followed by a recovery phase.
Something much worse than this we think deserves a low probability. There is no strong evidence that the recent period of low volatility has encouraged the build-up of systemic risk on a worrying scale.
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