The passing of Yogi Berra, catcher, manager and coach for the New York Yankees and latter-day Mrs Malaprop, has robbed the world of a baseball legend and a reliable source of homespun, if off-key, wisdom. The future ain’t what it used to be, is one of the best-known Yogisms and captures well the current zeitgeist in markets. This year is shaping up to be the worst for risk assets since 2008, with both equities and bonds on course to underperform cash.
The negativism has three main sources: concern about the limits of monetary policy; the threat of deflation; and the prospects for emerging markets in general and China in particular. These three horses of market apocalypse have certainly spooked investors. According to Bank of America Merrill Lynch, emerging market equity outflows have hit $60 billion year-to-date, $22 billion from China.
After a first half that saw global equities up 6% and cash offering no return at all, the summer sulk has been surprising. Perhaps the biggest underlying concern is the nagging feeling that policy is ineffective. The three arrows of Abenomics have not been sufficient to jolt the Japanese economy back to life in spite of a monetary stimulus greater than we have seen in the US and Europe in a smaller economy.
The doom mongers believe Europe is turning Japanese. They are wrong. Japan faces a demographic disaster that will see its population fall dramatically over the next 20 years. No one is queuing at its border or making treacherous boat journeys to get there. Europe remains a magnet for the young, the ambitious and the hardworking. Growth is returning, PMIs are positive and the deflationary impact of lower energy prices will begin to wash through next year.
|The future ain't what it used to be, is one of the best known Yogisms and captures well the current zeitgeist in markets|
Monetary policy is far from exhausted in the eurozone. The European Central Bank could increase QE to Japanese levels and it could announce explicit price level targeting. The ECB could even introduce a tax on cash transactions so it could cut interest rates further into negative territory without the fear of euro notes being stuck under mattresses.
Policy could get that radical because the biggest threat to the eurozone is not Grexit, Brexit, Nigel Farage or Marine Le Pen. Debt deflation would prove more calamitous. Deflation would cause the real value of nominal debt to grow. That would be disastrous for the Pigs (Portugal, Ireland, Greece and Spain) and cause the eurozone to rupture. The end game is a single European treasury with the ability to make fiscal transfers. Until we get there monetary policy can and will take the strain.
There are enough monetary bullets left to ensure the eurozone does not tip into deflation. Given that inflation breakevens are lower than the stated policy target it may even be a good time to buy hedges. What complicates the picture is emerging markets and how they are influencing policy.
At the margin, the decision of the People’s Bank of China to devalue the yuan is exporting deflation. But the fear that this is somehow signalling a dramatic economic slowdown seems a hysterical response. The Chinese authorities have plenty of scope to support growth. The low PMI reading is a classic example of how market participants cling to confirmation bias through random data. A PMI does not reflect real output. It asks for purchasing managers’ expectations. Those expectations are relative to the previous month rather than being absolute.
Talk of a generalised emerging market crisis is also wrongheaded. Countries such as Colombia, which has seen its currency fall by 20% against the US dollar in 2015 and the price of its main export (oil) halve, is still expected to grow at 4% in 2016. Inflation is under control. The best-run emerging market economies have put in place contra-cyclical measures to deal with commodity price declines. Chile’s Copper Stabilization Fund is a shining example.
Those running to the exits in emerging markets should be far more discriminating. There are basket cases, but there are also fantastic opportunities. The new narrative that we are heading into a worldwide recession in 2016, which will largely be made in China will likely be proved very wrong.
As Berra advised, investors should take all of this gloom “with a grin of salt”. The time to get worried will be 2017 and 2018 when a lot of short-term debt will need refinancing and policy rates are likely to be higher. But those higher rates will reflect sound economic conditions and will be broadly positive for markets. For now, risk assets are starting to look cheap and there is a tactical buying opportunity.
PS: Before this column is dismissed as the mumblings of Pollyanna, it is worth considering the track record. Early in 2007 we highlighted “hangovers” from market excesses, in particular, “the swamp of structured credit”. In June 2011 when Glencore floated we asked if it was time to conclude the commodities bubble was over as the listing echoed the disastrous flotations of private equity firms in 2007.
Glencore’s share price is now less than £1, having listed at £5.30p. The piece quoted Berra: “it’s déjà vu all over again”. The great man definitely got that right.