Turmoil in financial markets

Goldilocks and the bears

Investors have been forced to reassess their rosy view

EQUITY markets started 2014 in a buoyant mood, after 30% gains for American shares in the previous year. Investors seemed to believe that the worst of the financial crisis was at last over and that the global economy was returning to “Goldilocks” mode, with growth neither so strong as to cause inflation nor so weak as to squeeze profits, but “just right”.

However, markets have been hit by a classic one-two punch in the opening weeks of the year. First, emerging-market currencies came under pressure, with the Argentine peso and Turkish lira, among others, falling sharply and several countries opting to increase interest rates. To add to the concern, Chinese economic data showed signs of weakness, with the purchasing managers’ index for manufacturing dropping to 50.5 in January, its lowest level in six months.

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The second sandbagging came from America, where the purchasing managers’ index for manufacturing slumped to 51.3 in January from 56.5 in the previous month. That was accompanied by a 3.1% decline in vehicle sales in January compared with a year earlier and followed a surprise 4.3% fall in durable-goods orders in December. The news prompted a 2.3% fall in the S&P 500 index on February 3rd. Most analysts had dismissed weak employment numbers for December as an aberration due to exceptionally cold winter weather, but the run of disappointing statistics seems to have stirred second thoughts. Payroll data for January, which were due to be released after The Economist had gone to press, may assuage or amplify these misgivings.

Underlying all this is a third potential worry. The Federal Reserve’s policy of “quantitative easing” (creating money to buy assets) is widely credited with propping up equity markets as well as depressing bond yields. Now that the Fed is “tapering”—that is, gradually reducing—its asset purchases, will the markets come under prolonged pressure?

As always, psychology plays a big role. The Fed is still buying $65 billion of assets a month, a significant level of support. The “forward guidance” it is giving suggests that an increase in short-term interest rates is far from imminent. Nevertheless, if investors expect the eventual withdrawal of monetary stimulus to prompt a decline in markets, it makes sense for them to sell in advance so as to reduce their potential losses. Indeed, the strong returns achieved from stockmarkets in 2013 may be reinforcing this process; investors are happy to lock in their profits.

The profit-taking trend seems well under way in Japan, even though the Bank of Japan is expected to maintain monetary easing  The broadly based Topix index fell by 4.8% on February 4th, having risen by 51% last year.

Profit-taking is not really the problem in emerging equity markets, since they have been underperforming stockmarkets in the rich world for the past three years (see chart). The worst-hit countries in recent weeks have been those with specific problems: political turmoil (Ukraine), a wide current-account deficit and high inflation (Turkey) or simply poor economic policy (Argentina).

But Raghuram Rajan, a prominent economist who is now governor of India’s central bank, has raised a broader issue. In the wake of the financial crisis of 2007-08, capital flooded into emerging markets, in part because their economies lacked many of the problems seen in the developed world and in part because central banks in rich countries had slashed rates so far that investors went abroad in search of juicier returns. As this money flows back again, emerging-market currencies (including the Indian rupee) are coming under pressure. That presents the countries concerned with a dilemma: let the exchange rate slide and risk inflation, or increase interest rates to defend the currency and risk a recession. “The US should worry about the effects of its policies on the rest of the world,” Mr Rajan says.

Judging by the behaviour of markets in recent weeks, many investors have been consumed by the opposite concern: will the difficulties in emerging markets infect the developed world? Analysts at Macquarie, an investment bank, point out that five of the countries that have seen their currencies fall the most (Argentina, Brazil, India, Russia and Turkey) comprise 12% of the global economy. Around 18% of European corporate revenues derive from emerging markets, according to Goldman Sachs, and that rises to 24% for Britain and 31% for Switzerland.

About 15% of the profits of S&P 500 companies come from emerging markets. As yet, there is no sign of problems in corporate results. Bank of America Merrill Lynch estimates that, as is the custom, most American companies have beaten earnings forecasts for the fourth quarter. With 70% of companies in the S&P 500 having reported, earnings per share have risen at an annual rate of 7%.

But Wall Street does not have much margin for error. Profits are close to a post-war high as a proportion of GDP. Meanwhile, equities look expensive by two of the best long-term valuation measures, which are calculated in quite different ways. Price-equity ratios, which relate share prices to a ten-year average of profits, are now around 25, far above their long-term average of 16. Shares look equally expensive when measured against the cost of replacing companies’ assets, a metric known as the q-ratio.

Bad news for equities has proved positive for government bonds, even though the Fed is buying fewer of them. The yield on ten-year Treasuries dropped from 3% at the start of the year to 2.59% on February 3rd, and yields on ten-year German bonds fell from 1.94% to 1.56% over the same period. Whereas sentiment on equities may have been overoptimistic at the end of 2013, it may have been too pessimistic about bonds; inflation is lower than it was a year ago in America, Britain and the euro area. The Economist’s commodities index has dropped by 13.9% over the past year and copper, often seen as especially sensitive to economic conditions, is down by almost 15%.

The wobbles in financial markets so far this year can be explained as a timely reassessment of what had been an excessively rosy investor outlook. For the sell-off to turn into something more serious, it will probably need clearer evidence of a new economic slowdown, in either China or the developed world, or a significant hit to corporate profits.