Tuesday, August 20th, 2013

Indian Summer

Superficially the Indian devaluation crisis is a story about a boom in foreign investment, followed by rapid growth in domestic consumption and an asset bubble, and then the onset of the crisis as the current account deficit runs out of control and the currency starts to depreciate. As often happens in this situation, there is a contagion process which affects other countries, starting with those which have a high current account deficit, and then spreading to all emerging markets which are deemed to be vulnerable, irrespective of the facts. The currencies of countries as diverse as India, Malaysia, South Africa, Turkey and Brazil are now trading within 10% of the bottom of their range against the US dollar over the last 52 weeks. Once the contagion phase sets in, the fact that a country like Malaysia has a current account surplus no longer seems to count for much.

Our asset allocation models have been telling us to avoid emerging market bond and equity markets since the end of the first quarter. The highest ranked emerging equity market of the 44 countries we track is Malaysia in 22nd place. 7 out of the bottom 10 countries are emerging markets including Chile, Peru, Brazil, India, Indonesia, Thailand and Mexico. Because this recommendation was (a) so early and (b) has been so consistent, we believe that the debate about current account deficits risks confusing the proximate with the underlying cause. In our view this is a liquidity crisis caused by the looming threat of the Fed taper. Back in 2009 emerging market equities exhibited some of the strongest gains as QE took effect, so it seems only reasonable that they should be hit hardest as the Fed reverses policy.

The real question is whether we should extend the same logic to the US equity market and diarise a liquidity-induced sell-off sometime between Q4 2013 and Q2 2014. Our view is yes, but only a small one. The Fed does not set monetary policy for any country apart from the US, so what happens to their equity markets or currencies is not an object of policy, even though it may be a consequence. But the US equity market is different. The relationship between the level of the equity market and the wealth effect on US consumption means that it is every bit as important as the level of unemployment in determining monetary policy.

We don’t expect to hear any of the Fed governors confirm this, even on a temporary basis, but it is not too difficult to establish a range of values for the S&P 500 on a purely empirical basis. We note that the debate about tapering did not really kick off until May when the index was around 1650. When it fell to 1560, most commentators felt that this would cause the taper to be delayed. This is not scientific, but we believe it is possible to discern a cap and collar arrangement in these numbers. Any level above 1650 (and certainly 1700) means that conditions are right to initiate the taper during Q4. Any level below 1550 (and certainly 1500) means that the taper would have to be postponed or possibly “untapered” if it had already started.

Using 1550 as our level, this implies a correction of about 10% from the peak (and 6% from current prices). This is not a pleasant prospect, but it is perfectly manageable in the context of recent gains. More importantly, if/ when the taper goes ahead, there will also be an impact on Treasury yields. The difference is that equity markets will recover after the correction, but bond yields will still have further to rise.

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