“Take a deep breath….everything will be okay.” This is something I find myself saying to my kids, who live so in the moment, that anything upsetting right now, might seem to them like it could last forever. Of course, usually within about 10 minutes they have completely forgotten about it and are happily playing again. But it also seemed like a pretty good message for market participants yesterday. Either that, or don’t ever [EVER] turn on CNBC when equities are [favourite word of the day] “tanking”. Or any other time really, for that matter.
Don’t get me wrong, the price action we saw yesterday was pretty frightening. Particularly when you see it spread across asset classes as it did early-afternoon UK time, when JPY collapsed (appreciated), sending shudders through the rest of FX. According to Bloomie, NZDJPY was down 10% for a minute or so, before recovering. Who knows whether anything actually traded at that level, but free-floating currencies should not have that kind of move.
Once again we are left asking the question about how deep markets really are these days. I know the drill – it is August, all the managers are on holiday, and so the kids don’t know what to do. But I’m not sure how much I believe that really matters these days. We are all connected, all the time. Perhaps the most interesting thing yesterday was the relative calm in rates markets. To be sure, they rallied as you would have expected, but it was all very orderly and far from the extremes we saw last October. Indeed, as I type this, as the market has generally calmed this morning, 10 year Bunds are actually yielding slightly more than they were over a week ago, before the equity markets started “tanking”.
I am not going to even try to retro-fit a story to why global equity markets have fallen so sharply. Most are pointing to China (combination of the SHCOMP falls, yuan deprecation and weak PMI) and the Fed (will they or won’t they hike soon) as the catalysts, but to an overly-long period of stable increases in equity markets that already looked toppy on some valutation metrics as the longer-term driver. They all seem plausible reasons for a mild correction, but not the sort of mass liquidation witnessed yesterday (and last Friday). Once one asset class liquidates, you get a self-reinforcing mechanism that spills across to other asset classes. With panic setting in, the fundamentals are irrelevant. The market will find a bottom eventually. But I was a little surprised that we heard nothing from the official sector yesterday. There was a financial stability risk if the panic had spread more widely across the asset spectrum, and some soothing words from the official sector can help in that regard. Of course actions speak louder than words, and so they (central banks) could have injected liquidity if necessary. Thankfully it wasn’t.
This morning has seen a stabilisation, with the main indices in Europe and US (futures) up around 3% from their closes yesterday. But the market is very skittish, so that calm could easily be swept away later this afternoon when the US comes in.
So while I don’t think fundamentals have much to say about the extreme moves over the past week, does the price action tell us something about the fundamentals? The big uncertainty is China (much more so than the Fed). Everyone knows the economy is slowing there, and has been for years. This is not a new story. It is also well-known that they have built up a worrying amount of leverage over the past 5-7 years. But are conditions deteriorating so fast there that rather than growing around 7% this year, it could be 3%. I doubt it. If that were the case, I think we would have seen a much stronger policy reaction in China. They have the scope to aggressively ease fiscal policy and loosen monetary conditions. They have not (yet). The yuan depreciation looks to me like a very poorly implemented policy (see here for my recent post). A bit of a cock-up. It has given the impression they are not in control. Similarly, the piece-meal interventions in the stock market have also looked like they don’t quite know what to do. But if they were truly worried that growth was going to slow very dramatically (which would have far more serious consequences inside China than outside it!) then they would be throwing the proverbial kitchen sink at it.
Meanwhile, all this has brought into question whether those who are much further along in the cycle will once again put off raising rates. In particular, will the Fed look to wait beyond September, or even beyond December? And will the BoE wait until well into next year? Events of the past week no doubt make it a more difficult assessment. Domestically, both the US and UK are broadly ticking along as expected, a path that should lead to increasing rates. But is the rest of the world going to be such a drag that they can afford to keep policy looser for longer? If markets were to remain febrile for an extended period, then it seems very unlikely they hike this year. Because an extended adjustment would imply that the global fundamentals really have changed. Similarly, if sentiment was to turn south domestically, then there is undoubtedly a case for waiting. Inflation remains low, and assuming commodity prices do not rebound any time soon, will be lower over the coming year than previously expected. But if markets stabilise/recover and sentiment is not impacted at home, then I still see the case for starting the process of normalisation. And I think that for the Fed, December is the most likely (with a skew to September, rather than March) and for the BoE, February is the most likely (with a skew to November).
The euro area is another story altogether, and while growth has surprised on the upside this year, there remains significant downside risks. Those are greater given events in China, and the appreciation of the euro. Further policy easing may well be required, in the form of faster pace of asset purchases.
For the DM commodity countries (Australia, Canada and NZ), the outlook has also worsened and further policy easing across all three is highly likely, alongside further depreciation in the currency.
Finally, I have written (here and here) quite a lot recently about what I called the Troubled Three EM countries (Brazil, Turkey and South Africa). I continue to expect those currencies to weaken. What I had not expected was that Asia ex-Japan would get dragged into the mix, given the concerns around China.
So lots of opportunities out there for macro traders. Just take a deep breath…
Fundamental Macro 
The above is a decent summary of what happened yesterday. The one thing I’d also add is that I think one can no longer look at the markets, especially in the short-run, as a “fair” reflection of the “true state of the economy”. So much is driven by “positioning” rather than “proper investing”. In a sense, the average market participant is a trader now, rather than an investor — they are more concerned about risk managing “market narratives” rather than “real fundamentals”. This is what I meant last week by my “is the Fed market savvy?” comment/question. Should the Fed care that the SPX “flash-crashed” again (when it wasn’t supposed to happen again), like it’s 2010? No. Will they care? Probably. We are in an era where there is so much central bank interference in the “normal” functioning of the markets, that one can no longer talk about “fundamentals” per se, until one accounts for what the Central Banks will actually do. If the Fed missed their window of opportunity to raise rates, say 3 months ago, and if *now* they can’t raise rates because of “market turmoil” (read a quick, disorderly 10% SPX correction), will they be able to raise rates in a Presidential Election year? It’s all becoming a bit of a joke now with “financial stability” and political considerations, and what not.
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