Recent Volatility in Stock and Emerging Markets: How Worrisome?

February 4th, 2014 at 9:47 am

So you’re visiting some not-very-well-off friends and you think their not-very-stable house is on fire.  So you run across the street to the solid house of a well-off friend.  But you think you smell smoke there too, so you run out in the street, not knowing what to do with yourself.

That’s a slightly amped up version of what’s going on in global financial markets in recent days.

I generally resist commenting on twists and turns in the stock market because really, who knows?  But for the past few days markets have been responding to some interesting global dynamics that are worth a closer look.

Yesterday’s big losses—S&P down over 2%–relate to the short story above.  There’s been a flight to safety in recent weeks from emerging markets to advanced economies (over $6 billion from EM equity funds just last week).  But yesterday started out with a surprisingly weak report on US manufacturing, which follows a weak durable goods report and the surprising soft December jobs numbers (which I’m betting gets revised up in this Friday’s release).  So when the flight to safety looks less safe, you get a big selloff.

How worrisome is all this?

–A lot of what’s happening is rebalancing.  Both US and Japanese equity markets, up about 30% and 60% respectively last year, are overvalued and need to correct.

–Similarly, large investment flows to EMs were driven less by fundamental analysis and more by looking for returns in a climate where US bond yields were low (e.g., Fed funds rate near zero), growth was just OK, and investment domestic opportunities were not plentiful.

–Thus, it doesn’t take much to cue a mini freak-out.  In this case it was the Fed taper, slower Chinese growth driven partly by more internal investment and consumption (another very important rebalancing act), and jitters about the quality of governing, fiscal, and external accounts (trade deficits) in the EMs.

–Add in nervousness about yet another US economic head fake and you get the picture.

“Um…dude…you didn’t answer the question: how worrisome?!”

Right.  My bad.

I’m 58% not too worried.  The hard numbers don’t look so bad.  For example, our exposure to the EMs is minimal.  The US share of exports to EMs in general is about 5% of GDP, and to the specific countries hit by the outflows, it’s less than 1%.  Banks assets and corporate profits are similarly sized.  An equity market correction was, as noted, in the cards, and the US growth picture is likely better than some of these recent downside surprises suggest.

But that 42% ain’t nothin’ either.  It’s less about the numbers and more about the psychology (that’s why the work ‘think’ is in bold above) and correlations of contagion.  When large capital flows start moving around like the guy smelling smoke up there in the intro, there’s increased volatility, impatient if not downright skittish capital, and a lousy climate for investment in lasting projects that undergird lasting growth.

You also get the correlations I worry about here, where nervous investors all respond in chorus to the same perceptions, which may or may not be real.  Instead of one guy running out into the street in his jammies, you get a whole crowd running out of all the houses and onto the cul-de-sac…and that can’t end well.

And yes, the 42% also includes head fake risk.  My readers well know that I’ve been a staunch advocate that it takes more than just growth to get things back on track here in the US economy.  But it definitely takes growth.  I’m not talking recession risk–I think that’s very low.  I’m talking sinking back into slog risk, i.e., growing 1-2% instead of 3-4%.  And even the latter is still slow given the output gaps that still exist.

I noticed that the US markets opened with a rebound today after yesterday’s selloff, so go figure.  Like I said, who knows why indexes bump and grind on a daily and intra-daily basis?  But these larger issues are very much worth keeping a close eye upon.

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2 comments in reply to "Recent Volatility in Stock and Emerging Markets: How Worrisome?"

  1. Larry Signor says:

    I have been thinking about ” yet another US economic head fake”, and have come to the conclusion there are two words that will preclude this event, Obama Care. It is working and with the subsidies it will reverse a great deal of the recent austerity. Could this be the jobs program we have been wishing (screaming) for? 6-7 million new healthcare consumers (I know not all will be new, but the subsidies should free up some income to be spent elsewhere), Ancillary jobs, infrastructure expansion jobs, education jobs…all fueled by the ACA subsidies. I think we are on the verge of an economic expansion like nothing we have seen before.

    Paying for this oncoming boom may adjust the dollar so that our trade deficit improves, as well. As my man Joe said, “this is a BFD”, in many more ways than one.

  2. purple says:

    Margin debt is at record highs and the EM growth was supposed to save the world right ? EM share is small but as a percentage of growth it is far larger.