The US equity markets suffered their worst week since the summer of 2012 according to Bloomberg. Out of the major markets, only Canadian and Italian benchmark indices are higher so far this year. Losses are admittedly still modest in developed Western markets with the S&P down 3%, the FTSE All Share down 1.6%, and Europe down 2.6%. Japan is lagging having fallen by 5.5% although in USD terms the loss is reduced to 2.8%. Further afield, emerging markets collectively are down 8.5% as measured by the iShares ETF.
At the end of the year, opinion was almost universal that 2014 was going to be another good year in equity markets. So, what is going wrong? Is the negative performance so far in January just a short term blip, or perhaps the signal that the tectonic plates are beginning to shift?
The consensus is that negative news from China and the poor performance from emerging market assets can be blamed for this week's losses. We don't disagree. We would also point out that markets are vulnerable when investors become too bullish or complacent especially, as we have been pointing out for months, when valuations are stretched.
So, what is happening in China and emerging markets, and should investors be worried?
Having underperformed developed markets for three years between 2011 and 2013, emerging markets have started very poorly in 2014. We all know the basic story; some US$4 trillion poured into emerging markets in the immediate aftermath of the previous crisis as global central banks flooded the system with liquidity. For a time, emerging markets was the consensus trade as liquidity and recovery prospects combined with the Chinese growth on the back of the massive (and we mean MASSIVE) late 2008 stimulus package.
From a cyclical perspective, the emerging market equity trade quickly lost its allure. Global economic growth has been relatively weak compared to past cycles as Anglo Saxon economies struggled to reach escape velocity, Europe ex. Germany stagnated and Chinese (debt fuelled) growth slowed. For those investors in emerging market debt and FX, this was a simple, yet turbo-charged carry trade. As noted in Friday's FT, carry trades are like picking up pennies in front of a steamroller: every now and then you get flattened.
But the situation could be much worse than a simple EM shakeout. Although we will never know the true extent of malinvestment, the potential for losses in EM is significant. We are not simply talking about losses on the US$4 trillion that flowed into EM since 2009 (although losses here are surely rising), the biggest concern surrounds China and the size of losses on their mountainous debt.
In the last 5 years of so, the increase in private debt is almost equivalent to the size of the US banking system, or in dollar terms, over US$12 trillion (according to Bloomberg data for Total Social Financing at current exchange rates). This rapid increase in debt eclipses both the period before the bursting of the Japanese bubble in the late 1980s and the US in the 2000s. With the level of embezzlement that has occurred in China over the last 5 years, and the lack of cash flows to service the new debt created, it is naïve to believe that China does not have a massive problem. Like any debt bubble, it is impossible to know when the moment of truth will arrive (the so-called Minsky moment), and in China, they have the political sway within their financial system to delay such a moment for a long time, but losses are losses which will need to be dealt with one day.
So, with rumours about a potential default on a Wealth Management Product(WMP) in China at the end of January, global markets are suddenly worried about China's Minsky moment. Will the WMP be bailed out? Perhaps, but that is only disguising the losses and shifting them from the investors onto either the bank that sold them or the Government. In the big picture, it does not really matter whether this WMP is bailed out or not, because the Minsky moment will arrive at some point and total losses will epic.
Frankly, we do not have the space here to do justice to the size and complexity of the potential problems in China, but with emerging markets now struggling in her wake, developed markets suddenly seemed to wake up to the developing downside potential. In fact, there are shades of 1997 here in that developed markets took a long time to wake up the Asian/EM crisis at the time. In late 1997 and again in the Autumn of 1998 developed markets suffered short but sharp losses.
In the wake of the 1997 Asian/EM and 1998 Russian collapse that ultimately brought down one of the largest hedge funds at the time, the FED along with US Treasury/IMF and other central banks stepped in to rescue the system. It was the usual cocktail of financial bailouts for distressed countries and interest rate cuts in the West.
The late 1990s stimulus arguably was the fuel for the developing technology bubble (along with the Fed boosting its balance sheet in late 1999 on concerns that the millennial date change for computers could go wrong and cause problems in financial markets) and of course, when that burst the Fed and other central banks slashed interest rates again. The monetary stimulus that the Fed supplied arguably was the fuel that caused the 2000's housing bubble, and we all know what happened next.
And so back to the question posed near the beginning; Is the negative performance so far in January just a short term blip, or perhaps the signal that the tectonic plates are beginning to shift? Should China not be able to cope then it is the tectonic shifts that investors need to be worried about. Furthermore, if equity markets start to fall, and selling momentum gathers pace, the Fed have limited options available to them. Interest rates are at zero already and they just told us that they are unsure about the efficacy of QE. They could risk their credibility and simply print more money. Likewise China could reverse its recently stated policy and accumulate reserves (which is their way of printing money; amounting to US$1.9 trillion over the last 5 years!)
Our point here is that central banks have very little new ammunition left to fight another battle if markets start to crumble. The risk in markets, we believe, is extremely high. The potential reward may be relatively modest. Of course, we do not know whether China will successfully kick the can down the road and investors may temporarily rejoice if the Fed continues to print money, but if these conditions persist, the macro risks will only get bigger and bigger.
We have been very defensively position in the portfolios we manage (with returns nicely positive so far in January) and we believe that this is the right strategy given the risks that are rising to the surface. Contrary to the bullish consensus, we do not believe that 2014 will be a calm year and we think that volatility across markets is set to rise and that buy and hold strategies (which admittedly worked so well last year) will struggle.