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Navalny is Russia's Hope, But It's an Uphill Struggle

My comment in today's FT reflects an unfortunate state of affairs. Russia is developing, socially and economically, in leaps and bounds. It certainly needs pluralism, and Navalny looks as good anyone could hope for. But even after a rare tactical win, the system is against him.

http://www.ft.com/cms/s/0/adaf757e-f084-11e2-929c-00144feabdc0.html#axzz2ZkqXWBbA

Technicals Count for Something

I loved this chart of EURCHF, as an exceptional argument in favour of technicals. Sometimes they are hard to deny.

Emerging Market Bond Conundrum

So, for 200 years, EM bonds have been hit when DM yields rise. It's not new.

What is new then? As EM to EM business has surged, and EM savings have boomed, so the ownership structure has changed.

Now EM investors constitute the core of EM bondholders. So, the sell off makes less sense, it is being driven by the marginal holders.

In short, there is already value in EM bonds.

The "Bernank" Bashing

There's been a healthy sell-off in equities, commodities and gold. USD has bounced back against most other currency pairs. Here are my thoughts;

It is important to remember that the Fed is not a very good market forecaster, so the expectation now reflected in market prices, of the Fed reducing QE in the coming months, is still very uncertain. In this context, Bill Gross is still calling for year-end US 10yr sub 2.0% (now 2.4%).

Ignoring this uncertainty, Bernanke sent a very strong message to the market. He was very clear about when the central bank expects QE to actually end. Although he also acknowledged aggressively that the FOMC Target (Interest) Rate is unlikely to move for sometime, even if the unemployment rate is doing well. This is obviously an effort to prevent an excessive collapse in long-term bond prices.

What’s happening now, though, is that the market has had its recent moves approved, and it has been given permission to push further. (Whilst many had thought that Bernanke would have used this speech to calm markets after a period of relative volatility.) The affirmed trend is mainly relevant in long-end bond markets. I’d expect the US 10yr to start pushing back toward the historical range. In 2003, when the Fed Target Rate went to 1.0%, the 10yr traded down to 3.0%, but spent most of the “exceptionally low” rateera in the 4.0-4.5% corridor. With this in mind, the fair rate now is arguably in region of 2.5% or more (which is consistent with many macroassessments).

Thus, we can expect continued outflows from long-bonds in multiple regions and currencies. (Interestingly, Germany's 10 year Bund is also reacting, up to 1.65% now from 1.16% in early May.)

For the moment, the equity selling is equally determined. But it doesn’t feel panicky, and I have the sense that it is more because events justify taking profits ahead of the summer lulls (as we end 2Q13) rather than because of anything else.

As for FX, it seems to have rationalised, with USD strengthening against EUR (1.32), JPY (97.8) and GBP (1.547). This makes more sense than the negative USD move we'd been experiencing recently.

At worst case, I’d be looking for an 8-9% correction on the S&P 500 Index, and certainly I’m trying to use this opportunity to convince clients to increase their investment exposure.

What's Wrong With Mr Market?

Markets have been moving a lot in recent days, so here is a quick summary of what is going on to help you navigate your investments safely though this period of volatility. 

US Federal Reserve Policy 

The trigger for change was news that there is an increasing readiness in the US central bank to reduce the scale of quantitative easing. For several years, the Fed has been buying large amounts of long-term US government bonds. When it reduces this intervention, it makes sense that prices on these bonds should fall, and so yields should rise. 

So, we’ve seen the US10yr bond move from 1.6% yield to 2.3%. Such a market movement has caused dramatic impacts on the prices of longer-term bonds around the world. We’ve been flagging this risk for several months, and recommended mitigating it by buying shorter-term bonds.

The important question on this aspect is, when will the Fed actually begin to reduce its interventions? Whilst there is a growing expectation, there is also a perception that it won’t come in the next few months. This line of thinking says that the Fed is readying the market for the possible impacts when it does eventually move. As such, it is taking the steam out of the market levels a bit. 

This is a constructive idea. The final outcome will depend on both macro data and the market’s readiness to cope. So far, the adjustment appears to be quite calm, despite some sharp price moves. If the economic data support a reduction of QE, and the markets seem able to digest it safely, then we will indeed see QE decline. Interest rate hikes are unlikely to follow in the near-term though. 

Emerging Markets 

We have also seen some quite negative dynamics in the emerging markets. For those of us watching the asset class, this has been disappointing if not entirely surprising. There are two key aspects. The first is positive economic developments in the US. The second is domestic developments in the EM sphere, especially in China. I summarise the situation in both below. 

Emerging markets have been part of the global financial system since the early 19^th century, when the first Latin American bonds were issued in London. Ever since then, there has been a clear pattern of global capital flows. When economic prospects improve in the developed world, money is drawn out of the emerging markets. This is an important factor, because it emphasises that the price movements in Emerging Markets today are driven by relative factors, and exceed fundamental factors. As a result, this correction offers a selective opportunity to buy. 

The second factor at play in the EM sphere at the moment is the dynamic inside emerging markets themselves. Notably, economic momentum has been slowing in key markets such as China, Russia and Brazil. Most significantly, China is now the world’s second largest economy, and its economic performance impacts sentiment globally. 

Yet, the story of emerging markets is arguably not nearly so bleak as the macro data point out. The mood remains quite vibrant across the EM sphere, with a sense that the growth path continues even if the structural drivers are changing. In Russia, for example, it is clear that the private sector is doing relatively well, with non-commodities businesses continuing to expand and improve. The headline GDP number is a factor of lower commodities prices and issues in monetary policy rather than domestic activity per se. 

In China, the five year plan no longer calls for 8% growth. China is now so big that such a rapid expansion is no longer required to sustain improvements in quality of life. The market has been slow to accept this, so it has been disappointed by some economic data in 1H13. Yet, the signs are clear that the government is pursuing its five-year plan constructively. China looks to be managing its development carefully, shifting growth drivers before they erupt into problems. But this means weaker economic data which are disappointing for global asset allocators, and lead to falling prices. 

The message from EMs is clear. We are seeing a shift in growth, which moves the focus to different areas of the economy. In particular, equities that give exposure to the EM consumer make clear sense now. If one looks for the growth, it is there, so the headline economic data are misleading, and the US growth story is compounding the problem. In particular, EM currencies continue to pay more than DM currencies, and should bounce back from the selling of recent days.

The trend may have slightly further to run, but prices of many assets are beginning to look attractive. For 2H13, we can look for expansion in key EMs. Not least as the DM growth story starts to feed through to global demand. 

What Comes Next? 

Overall, what’s been going on in the markets recently is an adjustment to a new paradigm. The markets are embracing the thesis we’ve been presenting for some time – that the US is on a relatively positive growth trend, which is gaining sustainable momentum. It is slower than that seen in previous recoveries, in part because of the nature and severity of the crisis, in part because the demographics and technology cycles are less powerful tail winds. But the move is in the right direction. 

Many people had sat out the rally, nervous of its sustainability. This, I would suggest may now change. If the light comes on in the end of the QE tunnel, it could bring an incredible amount of uninvested capital into the market.  For this reason, I would not wait too long to get into the market, and as China completes its transition to a more healthy growth path, the recovery should go global. 

It makes sense to use this correction to build exposure, and given that we can’t forecast how deep or shallow it may be, it makes sense to get skin into the game sooner rather than later. 

Global consumer stocks, USD, and heavily beaten down emerging markets assets are my investments of choice. 

This Week In The Market

The S&P 500 lost 1.1% last week, and Emerging Markets lost 1.7%, whilst the EuroStoxx 50 was flat (+0.2%). Russia had a difficult week, losing 2.2% as EMs succumbed to sharply shifting capital flows. The US 10 year treasury yield rose by 12 basis points, and at one stage crossed the 2.20% line. What is going on, and what can we expect for the coming week?

The answer to the former question is that markets are reviewing expectations about monetary stimulus in the US. This should not be a surprise, we’ve been flagging for months that the US economy is doing relatively well, and recent minutes from the FOMC reflect a growing interest to start reducing monetary expansion, the precursor to tightening policy.

The behaviour of Emerging Markets, not least Russia, is a natural consequence of this circumstance. Improved yields in the US will lure money from perceived riskier environments. The upshot is “unfair” on emerging market assets, which ultimately stand to benefit from improved US growth. But it also provides attractive entry opportunities. The relative stability of European assets reflects the perception that interest rates in the single currency area are on a significantly different path at this time.

The coming week brings a veritable flood of important economic data. The most eagerly awaited is Friday’s jobs number, but we will also get ISM data, US trade data, European retail sales and GDP, BoE and ECB rate decisions, German exports and Chinese consumption data. The ebb and flow of this data will drive markets, but beyond this we should consider that the volatility that proceeds monetary tightening tends to provide a good opportunity for investment.