It goes without saying that this past week is not one that will be soon forgotten. In light of the recent coordinated government interventions, I would expect money markets to start behaving more normally, and ever so slowly as risk aversions start to fade we will start to see an increased interest in corporate in bank debt which should assuage the equity market’s fears and allow them to become more calmed. This is not to say I am calling a bottom, I am just pointing out that the recent high volatility (highest recorded level on the VIX, although technically the VIX would have been higher during 1987 (somewhere around 150 vs. 70 or so now, it just wasn’t around then) can be expected to dissipate at as people become more risk tolerant.
Speaking of bottoms, I just wanted to make a quick note on where and how I think we can bottom. In order for the markets to bottom, house prices will have to stop their decline. Now many people are predicting a price bottoming in the first quarter or second quarter of 2009 which is when many sub-prime resets will taper off. Although this is somewhat logical they are ignoring the wave of Option ARMSs and Alt-A which reset in 2010 and 2011. These will cause significant pain should their reset be anything like the one we went through with sub-prime resets.
Before we get into the meat of this week’s post I just want to take a minute to say, those who took my advice and went short on ZOLT, it is probably now time to close that trade, since recommending the short on Sept. 7th the stock has fallen from $17.21 (Friday Sept. 5th close) to $10.00 (Friday Oct. 10th close) which represents a nice 42% profit in the span of about a month.
The turmoil in global financial markets has recently put pressure on nearly all emerging markets (EM) assets. In part, the move has been driven by concerns for the global slowdown and its possible impact on EM. On the other hand, economies like Brazil and Malaysia appear better shielded growth-wise when looking at typical macroeconomic shocks. Over the last month, however, the forces of financial deleveraging, risk aversion and positioning liquidation have taken center stage in driving asset prices. This has raised concerns among investors about the vulnerability of different emerging markets to broader strains in the financial sector and global markets.
The good news for EM is that there is no strong evidence that they are caught overly levered in the middle of this deleveraging process. EM fundamentals have improved substantially over the last few years and are still supportive in terms of economic stability and growth, overall. In fact, the current turmoil is much different than previous episodes of distress for EM assets; it is not an EM crisis, it is financial volatility imported from a shock that originated in G10 economies. However, the recent underperformance in EM currencies with stronger fundamentals stands as a reminder that financial turbulence can affect local assets in many ways, and not necessarily in connection with the economic performance of the country. There are different notions of exposure to financial volatility. Local assets can come under pressure through various channels; a disruption in international capital flow, a reversal of capital flows accumulated in the past, a strain in the financing of short-term external liabilities or some genuine fragility of the local financial system. On average, emerging markets appear to be more resilient than major markets on most indicators (exhibiting more resilience to shorter-term capital flows disruptions, short-term financing dislocations and soundness of the banking system).
Given the recent government moves what does this all mean in the FX space? The US trade balance will likely improve further. While exports will probably slow on the back of slowing global demand, US imports may slow even more on the back of extremely tight financial conditions and expectations of a recession.
Despite the US trade balance improvement, funding inflows into the US are likely to slow as well, given the weak cyclical outlook. Moreover, the Dollar is clearly less undervalued at current levels and further appreciation would probably make life more difficult for the export sector and hence not help the weak US economy. Therefore, after a stabilization of asset markets, we are likely to see first a period of renewed moderate Dollar weakness, before the longer-term appreciation trend towards fair value kicks in.
Slowing global growth will continue to put downside pressure on currencies that display a strong link to cyclical forces, such as the AUD. However, some of these currencies have depreciated rapidly in recent weeks and this may limit the additional depreciation risks.
Moreover, lower oil prices and substantial policy stimulus mean that growth rebounds are possible in the not too distant future, led by strong structural stories, such as the BRICs and N-11. Rate differentials are also likely to play in favor of EM currencies, in particular following the rapid decline of policy rates in major markets.
So net-net, I think given the sharp pull back it might be time to purchase some EM equities or balanced ETFs. Sorry for the brief post, but I have been at work all weekend and still have another two hours plus of stuff to get done.