The source of the current market correction is the massive misalignment of exchange rates, which finds its roots in quantitative easing.
Global CIO Commentary by Scott Minerd
The recent global equity market selloff reflects a long-awaited—and I believe ultimately healthy—market correction. A number of commentators speculated that after Monday morning’s sharp decline in U.S. stocks, the intra-day reversal indicated that we reached a bottom. In the very short run, I would agree. However, longer term, neither fundamental nor technical data support that we have reached the levels of capitulation associated with the end of a market correction.
One example is the Chicago Board Options Exchange SPX Volatility Index (VIX), often referred to as the “fear” index. While it spiked significantly higher, the VIX still failed to stay at the levels normally associated with capitulation like those experienced in 2011. Over the coming days I expect the market will try to find some short-term footing, but I doubt we have found a bottom yet. Buying risk assets now would be like catching a falling knife—if you do so you are likely to get quite bloody in the short run.
Dow could fall to 16,000 before finding a bottom.
The market rout has spawned numerous news stories attempting to explain the source of the sharp declines in global equities. Many have highlighted the decline in emerging markets, which, on balance, have now officially reached bear market territory, given the over 20 percent decline in the MSCI emerging markets index since April.
Some markets have done much worse, especially when measured in U.S. dollars. Brazil is the poster child for the ravages of a full-fledged bear market. Even with the devastating declines, emerging markets have yet to show any signs of bottoming based on either economic fundamentals or market technical indicators.
While in the U.S. fundamentals remain supportive of continued economic growth, technical indicators point to lower prices in U.S. risk assets. Looking at the S&P 500, the sudden collapse in prices should provide near-term support, but after some consolidation I would expect us to revisit the lows and ultimately test the 1,820 level. A decline to 1,820 on the S&P 500 would represent a 15 percent drop from the peak, which would be a healthy correction in a long-term bull market. As this correction plays out, I would expect yields on below-investment-grade energy credits to widen by another 200 to 300 basis points. Other equity markets and higher quality credit assets are likely to sell off in sympathy as well.
So what is causing all of this turbulence? The source is the massive misalignment of exchange rates, which finds its roots in quantitative easing. Case in point, consider Japan, which has weakened its currency by over 50 percent against the U.S. dollar, while China, Japan's largest trading partner, has basically pegged the renminbi (RMB) to the dollar.
Strains on the terms of trade between countries that have devalued and those that have not have built to the point that perpetuating these disparities is destabilizing to the countries that have staunchly fought devaluation. Witness China’s recent move to devalue the RMB versus the dollar, proving that artificial equilibrium is not only impossible to maintain, but ultimately disruptive to markets and economic growth.
Now we are facing the turbulent path to a new equilibrium. The coming weeks will be difficult and it is hard to hazard a guess as to when and how this will all end. Nevertheless, I place great faith in governments' willingness to use the printing press. It is a handy tool to prop up asset prices and temporarily spur economic growth. For that reason I don't see recession on the horizon for the G-7 nations or China either.
In time, policymakers will react. I would assume that the reaction time is fairly short. No one seems inclined to test the limits of how far asset prices can fall. Yet, given the current bias by the U.S. Federal Reserve to raise rates and the Peoples’ Bank of China to support the RMB, some more time will need to pass before more dramatic action is taken.
I would suspect that this will all climax by late October, but only time will tell. For the time being more downside risks remain. As I have mentioned before, cash is king, treasuries will outperform, and patience is a virtue. I don't believe we have reason for panic, but complacency is dangerous too. Look for opportunities and more signs of capitulation.
Misalignment in Exchange Rates Prior to the 1997 Asian Crisis
At the start of 1994, the Chinese government imposed a one-time RMB devaluation of over 30 percent against the U.S. dollar. However, valuations of eight other major Asian currencies* held relatively steady until 1997. The exchange rate misalignment was followed by a painful correction in currency value that triggered the Asian financial crisis, in which a number of Southeast Asian countries were forced to break their currency pegs. Ironically, the reverse situation is likely the case today, with the average of the eight Asian currencies declining by over 20 percent against the U.S. dollar since the beginning of 2011, as opposed to the RMB, which appreciated by 3 percent in the same period.
Currency Valuation against U.S. Dollar
Source: Bloomberg, Guggenheim Investments. Data as of 8/24/2015. Note: Other Asian currencies include Japanese Yen, Korean Won, Taiwanese Dollar, Thai Baht, Philippine Peso, Indonesian Rupiah, Malaysian Ringgit, and Indian Rupee.
Economic Data Releases
Economic Activities Continue to Expand in the U.S.
- The Chicago Fed national activity index rose to 0.34 in July from -0.07 in June, beating expectations of 0.2. The improvement was mainly driven by production-related indicators, which contributed 0.28 of the index growth.
- U.S. flash manufacturing purchasing managers’ index (PMI) for August fell to 52.9 from 53.8 in July. A reading above 50 signals expansion.
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