Putting the global sell-off into perspective
A combination of factors has led to a sharp correction in equities in recent days. Putting the sell-off into perspective, we explain why we should see a positive environment for risk assets going forward.
The depth and rapidity of the sell-off in global equities over recent days has been breathtaking. Following a sharp decline in the major US benchmarks, markets across Asia essentially collapsed, with North Asia – down 5%–6% – hardest hit. Selling subsequently continued in Europe with every major market in the red.
Since the recent peak in global equities towards the end of September, we see a similar picture, with Emerging Asia, more specifically China, falling over 10%, whereas other EM were only down modestly, and Latin America is actually almost 5% higher, even with the correction of the last two days. Up until the start of this week, global bond yields were rising sharply, but fell amid the worst of the equity correction this week.
No easy answers
Precisely why global risk markets should post such a precipitous decline is not easy to answer, but is likely to be a combination of factors. They include the bumpy and uncertain path to global interest rate normalization, rising uncertainty around US-China trade relations and how it will impact Chinese growth and a disappointing start to the corporate earnings season. These factors, combined with what appear to have been quite extreme imbalances in positioning within equity markets, have led to a forced liquidation of positions by some market participants and caused contagion across markets.
Spells of uncertainty not uncommon for risk assets
It is worth remembering that central banks typically embark on rate hiking cycles when the economy is doing well. This is why, across all monetary tightening cycles of the past 30 years, risk assets have tended to ultimately do well. It is not uncommon to have periods of volatility; however, we see few signs that a material rise in core inflation is likely, and if the economy ends up being very strong, it is not a bad scenario for risk assets.
No signs of crisis in emerging market assets
While Chinese equities have now underperformed the USA by the most since the late 1990s as trade tensions with the USA simmer, we see no evidence of an imminent crisis in emerging markets or China. Balance sheets are much healthier than in past emerging markets scares, and imbalances are much less. We thus stick to our positive view on emerging markets assets and think the outcome currently priced in markets is far too extreme.
Re-enter markets gradually
So what happened? Was it a correction or inflection? And do subsequent price declines represent buying or selling opportunities? We think the answer is that it is a correction and not something more sinister. Overall, we expect slightly lower but still very robust global growth and subdued inflation. Importantly, the bond market is now priced in line with our expectations of one more Fed hike this year and two next year. Putting all this together, we should see a positive environment for risk assets going forward, and with the current level of US bond yields, it is difficult for us to see a strong rally in the USD from here or a further large rise in yields. This should further benefit emerging markets.
We do not recommend rushing back into markets here, but instead to do so in steps and focus on areas where value is best, which in our view is emerging markets. Outside of Asia, we also think it makes sense to add some USD duration given the sharp rise in yields, and that market pricing for the Fed is in line with our views. This would also add some protection to portfolios in the case of a real slowdown in growth.