Global Markets Throw a 'Taper Tantrum'
A sharp sell-off in the global stock markets so far this year has left many small investors a bit puzzled and panicky, and unsure how to react. Retail investors in the US, who watched the from the sidelines in a state of disbelief, as the "Least Loved" Bull market on Wall Street, continued to climb to new all-time highs, - finally decided to throw in the towel in the second half of 2013, and jumped aboard the Bullish bandwagon. The late converts plowed $175-billion of their savings into US-equity funds, helping to push the S&P-500 Index to an all-time high at the 1,850-level. They gave little thought that maybe, the "Least Loved" Bull had climbed "too far and too fast" after gaining +175% from the Great Recession low.
January is usually a bullish month for US-stocks. So when the Dow Jones Industrials stumbled out of the gate, sliding -7% so far this year, it raised a warning flag. It means that 2014 will be a volatile year. On Wall Street - the word "Volatility," is a code word for sharp declines in the market place that are expected to happen frequently. Even if the US-stock market recoups its early losses in the months ahead, it could come under renewed selling pressure again. In other words, the investing landscape has become more treacherous.
That's especially true because the S&P-500 index is fast approaching its fifth birthday on March 9th. And at 59-months old today, the "Least Loved" Bull rally is 4-months beyond the median age of the Top-12 Bull markets in history. As it enters its retirement years, it becomes frail, and more vulnerable to unexpected shocks. Traders that study cycles have also noted that t he S&P-500 index hasn't suffered a correction of -10% or more for 30-months. That's remarkable, since historically, -10% corrections happen about 20-months apart, on average.
Not to forget the stock market will have to deal with the Fed's dialing back its high octane liquidity injections, a policy shift that will force the QE-addicted stock market to stand on its own two feet. Most traders are completely unaware that the Fed has already started draining excess liquidity on a daily basis, through reverse repo operations. On Feb 4th, the Fed drained $106-billion at 3-bps from 60-bidders. Thus, the Fed is partly sterilizing its QE-injections, which in turn, is helping to support the US$'s exchange rate. Still, investors can expect the "Plunge Protection Team" (PPT) to intervene in the stock index futures markets, whenever panic selling erupts, in order to prevent a disorderly slide from turning into a horrific crash.
On February 3rd, the Dow Jones Industrial average plummeted 326-points - continuing the steep sell-off from January. The Dow has shed more than 1,200-points, and its year to date losses total -7.4%, while the broader S&P-500 index plunged to the 1,742-level, and is down about -6%, -- the most it has fallen since its initial Taper Tantrum was unveiled in late May - late June of 2013. The Perma-Bulls on US-equities were caught of guard as were the latecomers to the QE-party, and were surprised by the sharp pullback, because their radar screens weren't focused on the downturn in the Emerging currency markets.
"A trend in motion will stay in motion, until some major outside force knocks it off its course." While it's best to ride the gravy train for as long as possible, contrarians are also mindful to spot the contradictions between the mix of macro-economic data and the mix of the global markets. Such was the case in the fourth quarter of 2013, when a wide mismatch was unfolding. Most notably, - there was a sharp slide in the exchange rates of the Australian and Canadian dollars and the Emerging market currencies, versus the value of the US-dollar, and other the other side of the equation, yen carry traders were bidding up the exchange traded funds linked to the German DAX, Japan's Nikkei, and the US-stock market indexes.
In hindsight, the widening divergence was unsustainable. But contradictions between the real economy and the market can be long lasting. "The market can stay irrational longer than you can stay solvent," John Maynard Keynes used to say. So the Macro Trader was patiently waiting for a notable change in sentiment before placing a contrarian bet. Market sentiment can change instantly and without warning. As is typical in a Bear raid, - an eight day slide in the S&P-500 index wiped out the gains over the previous 67-trading days.
The catalyst for the sharp pullbacks in the German, Japanese, and US-stock markets was the meltdown in the exotic Emerging currencies and even currencies with AAA bond ratings. Since May 1st 2013, - the Turkish lira has plunged -22% lower, South Africa's rand tumbled -20%, Brazil's real tumbled -18%, Chile's peso fell -16%, and the Russian rouble fell -12% against the US$. The Aussie and the Canada's Loonie tumbled -15% and -9% respectively. There was a notable unwinding of the "yen carry" trade, against the Euro and US$. The Bank of Japan (BoJ) is nursing a yen carry trade that contains hundreds of billions of leveraged bets.
Global investors pulled $15-billion from the Emerging stocks and $36-billion from Emerging market bond funds in the second half of 2013. But these trades are just a drop in the bucket, compared to the $4-trillion of foreign funds that was plowed into the emerging markets since the Bank of England (BoE) and the Fed began their QE-schemes in March of 2009. It's estimated that $440-billion of the BoE's and the Fed's "hot money" flowed into Emerging market bonds, equities and liquid instruments that can be sold quickly.
With the Fed slowly tightening the money spigots, life will be more difficult for the "Fragile Seven" Emerging countries - Argentina, Brazil, India, Indonesia, Turkey Russia, and South Africa - that account for over 17% of global GDP. Recently, central banks in Asia and Latin America were forced to jack-up their interest rates to stave off currency collapses and a wholesale exodus of foreign investors. Brazil, Turkey, India and South Africa hiked interest rates in January, but whether these steps will steady the currencies is unclear.
However, one thing is sure - economic growth, Emerging countries' main trump card over their richer peers, will take a hit, as a result of the recent upward spiral in their local bond yields. The aftershocks are already reflected in the value of the iShares Emerging Markets ETF (ticker symbol: EEM), its down -15% compared with a year ago, and others have fared worse. The iShares for Turkey ETF (ticker: TUR) is -39% lower, the iShares for Brazil is -31% lower, and Market Vectors Russia ETF (RSX) is -20% lower, - among the worst performers.
High Frequency Algo's Slam Japan's Nikkei-225 index, Although the dark clouds over the Emerging markets have been gathering force for many months, it wasn't until January '14, that the equity markets in the G-7 arena suddenly began to react. Last year, Japan's Nikkei-225 index had beaten all other benchmarks, it was up +57%, fired-up by Prime minister Shinzo Abe's all-out campaign to crush the exchange rate of the Japanese yen. The correlation between the booming Nikkei and the weakening yen's exchange rate was three times the 10-year average. But in what Japan's economy chief Akira Amariit calls an "excessive reaction" to the Fed's tapering of QE - the Nikkei-225 index plunged as much as -14% lower to the 14,000-level, since the start of this year.
Tokyo stocks, which rely heavily on fickle flows of money from foreigners, have suffered the third worst start to a year in the past half century. According to the Tokyo Stock Exchange, 70% of the daily liquidity in its main section is driven by foreign investors. Likewise, High-Frequency Trading (HFT) that uses complex algorithms, to transact a large number of trades at very fast speeds account for 70% of the daily trading volume in Tokyo stocks. On Feb 4th, HFT cowboys from the Western world pummeled the Nikkei-225 index, slamming it 610-points lower, or -4.2%, to close at 14,008. Losers trounced winners 1,764 to 13 in the first section, while three issues were unchanged. Volume increased to 2.9-billion shares. On the previous day, the Nikkei was dumped for 295-points.
The trigger for the sharp decline was the weakening of the Euro, the US$, and the Emerging currencies against the value of the Japanese yen. In New York trading, the US$ briefly fell to ¥100.77, and with the Euro also slipping towards ¥136 in Tokyo trading, the Nikkei average extended losses late in the afternoon session, hit by unwinding of futures-linked arbitrage positions amid a growing "risk off" mood. The Nikkei Stock Average Volatility Index climbed +10% in a single day, to its highest level since July, indicating that traders were caught flat footed by the turmoil in Emerging currency markets.
The Wisdom Tree Emerging Currency Fund (NYSE ticker: CEW) - a basket of equally weighted currencies in Brazil, Chile, Mexico, Hungary, Poland, Turkey, South Africa, China, India and South Korea also plunged by as much as -6% against the Japanese yen from Jan 1st thru Feb 3rd, to ¥1,960 /share, and whipped-up selling in the Nikkei-225 index. The sharp devaluation of the emerging currencies will deliver a double whammy for Japanese exporters, such as Toyota Motor (7203.TK) which derives 42% of its sales in the Emerging markets.
However, Tokyo's financial warlords are monitoring the currency and equity markets 24-hours per day. On February 5th, Bank of Japan deputy Hiroshi Nakaso drew a red-line in the sand, by threatening to increase the size of its ¥7-Trillion /month, QE-scheme, if necessary, to stop the slide of the Euro and US$ against the Japanese yen. "It's important to steadily proceed with the BoJ's quantitative monetary easing," Nakaso told parliament. "But financial markets, including those for Emerging economies, are making jittery movements. If some kind of risk materializes, we will take necessary policy adjustments," he said.
The Jawboning worked. The US$ rebounded to ¥102 the next day, and the Euro jumped ¥2-½ to ¥138, which in turn, ignited +1% rallies for the German DAX and Dow Jones Industrials, while relieving pressure on carry traders to unwind positions in Emerging currencies. There's a limit to how far Algo traders are able to frustrate Japan's Ministry of Finance.
Brazil Trapped in 1970's-style Stagflation, Most emerging economies are still dependent upon capital inflows, to finance rising local currency borrowing, and therefore, these economies are very vulnerable to changing conditions in currency markets. And as the Fed turns off the spigot of global dollar liquidity, Christine Lagarde, the IMF's managing director, warned that spill-over effects from the Fed's tapering of QE-3 could destabilize vulnerable emerging countries that have failed to rein in imbalances. "It is clearly a new risk on the horizon and has to be watched," she told the World Economic Forum in Davos. Global fund managers are split over the gravity of the threat, but generally agree that there is going to be a big crisis, with Argentina, Turkey and Venezuela in the front line.
Brazil, Latin America's biggest economy contracted in the third quarter for the first time since early 2009 as a steep drop in investment showed flagging confidence in what was recently one of the world's most attractive emerging markets. Brazil 's economy shrank -0.5% between July and September. Brazil 's economy has slowed sharply since it capped a booming decade with +7.5% growth in 2010. Last year's growth slowed to +2.2% and some economists think the Brazil's economy could slip into a full blown recession in 2014. Brazil's industrial output slumped -3.5% in December, the biggest monthly contraction since December 2008, and was -2.3% lower compared with a year earlier. The delayed effects of monetary tightening bit deeper, and is a foretaste of what lies in store for a string of Emerging countries that have hiked short-term interest rates to defend their currencies.
Since last April, the Bank of Brazil has raised the Selic rate by +325-basis points (bps), starting with a 25-basis point increase, followed by six straight hikes of 50-bps. So far, however, the aggressive tightening cycle has put a roadblock in front of the US$ at 2.45-reals. But that still leaves the real -20% weaker against the US$ compared with a year ago, and in a vicious negative feedback loop - Brazil's 12-month inflation rate is running at close to +6% and above the central bank's upper target limit of +4.5-percent.
Since the Fed first telegraphed "Tapering" back in May '13, Brazil's 10-year government bond yield has spiraled upwards, - it's surged +425-bps higher to around 13.40% today, and is now suffocating the local economy. On August 22nd, Brazil's central bank said it would sell $60-billion worth of currency swaps, derivative contracts, and would sell $1 - billion on the spot market through repurchase agreements, by year-end, - aimed at bolstering the real, after it fell to near five-year lows against the dollar. It was a bold move, and capped the US$'s exchange rate at 2.45-reals. Subsequently, the US$ tumbled to around 2.16-reals, after the Fed surprisingly balked at Tapering QE in September.
However, the Fed soon began sending signals that Tapering was still on track, the US$ quickly rebounded to the 2.40-real level in December. On Dec 18th, Brazil's central bank made a tactical retreat, by downsizing its intervention to $1-billion per week, or half what it offered in 2013. On January 15th, central bank's monetary policy committee, known as Copom, voted unanimously to hike the overnight Selic rate a half-percent to 10.50% - its highest in two years, preferring to use interest rates as the primary tool to stabilize its currency.
Brazil 's currency is facing pressure on several fronts. Its budget deficit surged to $65-billion in 2013, and its current account deficit widened to 3.7% of GDP, because of weaker commodity prices. Its once bulging trade surpluses have dried up. Brazil's trade surplus shrank to just $2.5-billion last year. Central bank chief Alexandre Tombini will face another tough choice when the monetary policy committee meets in February. An eighth straight rate hike should help drive down inflation, and might strenghten the real, but a further tightening in monetary policy could undermine Brazil's economy further, and knock it into a recession.
In Sao Paulo, Brazil's Bovespa index fell below the 47,000-level on Feb 4th, as the yield spread between Brazil's 10-year bond and 2-year year note, narrowed to as little as +36-bps. An additional hike in the Selic rate to 11% could lead to an inverted yield curve, which in turn, could send a signal that traders expect Brazil's economy to contract in 2014. Yet the selling pressure on the real is expected to be unrelenting, if the Fed is tapering QE. Commodity prices such as iron ore and soybeans tend to be quite volatile. Economies tied to them, such as Brazil's, become so, too: when prices are high, the economy booms. But when they fall, the contraction can be severe. And there are already signs of a debt crisis brewing in China.
Russian Bear in Hibernation - The US$ has surged to its highest level against the Russian rouble in more than four years, a day after the central bank decided to abandon its currency interventions as part of its shift to a floating exchange rate. In Moscow, the US$ soared to 35.5-roubles, that's up +12% since the start of the "Taper Tantrum." On Jan 14th, the Russian central bank said that it was scrapping its targeted interventions, which had been worth $60 million a day, as it seeks to preserve its FX stash, which dwindled by $40-billion compared with a year ago. Without the support of central bank intervention, capital flight from Russia could resume this year. Russian companies and banks moved a net $62.7-billion out of the country in 2013, after shipping $54.6-billion out of the country in 2012.
The capital outflows from Russian continued in January 2014, with $17-billion fleeing the country, and may reach $35-billion in January-March 2014, Russian Deputy Economic Development Minister Andrei Klepach told reporters on Feb 6th.
The Russian rouble is under heavy attack, because the country's current account surplus has shrunk to an estimated $33-billion in 2013, down from $72-billion in 2012. The surplus is shrinking as rapid growth in imports outstrips less dynamic exports, a factor that will weigh on Russia's economic growth prospects and increase the rouble's vulnerability to external shocks. The central bank recently forecast that the surplus, which was 11% of GDP a decade ago, and +3.5% in 2012, will soon disappear altogether by 2016. It underscores the negative trends in Russia's balance of trade as well as the broader economy.
Some time ago, economists decided that Russia should be batched together with a group called BRIC -- that is, Brazil, Russia, India, and China, the major Emerging economies of the world. According to the IMF's revised projections, in 2013, the average growth rate for the BRIC's was projected at +5%. But by July '13, the Russian economy had already entered free fall. The growth rate for the first three quarters of 2013 was a miserable +1.3%. Growth of +1.4% or less is expected for the full year , making Russia the ugly duckling of the BRIC group, and the biggest loser by a long shot, bringing up the rear.
Russian kingpin Vladmir Putin's failure to root out corruption explains why the economy has ground to a halt. On Dec 3rd, the Kremlin admitted that Russia's oil and gas-dependent economy would stagnate over the next two years, and would lag other Emerging economies with a +2.5% growth rate per year over the next two decades. Unlike the central banks in Brazil, India, Turkey, and South Africa, which have raised interest rates in attempts to prop up their currencies, so far, Russia's central bank has maintained a hands-off approach.
Russia's rouble get hit whenever there is an Emerging market shock because 70% of the free float of the Russian equity and bond market is held by foreigners. The Russian Trading System Index has already tumbled -20% compared with a year ago, weighed down by capital flight, and the sharply higher cost of borrowing. Russia's 10-year bond yield is trading at 8.40% today, up +180-bps compared with a year ago. It's a great irony that Russia's 10-year bond yield has soared to 8.40%, far higher than the US's 2.70% rate, even though Russia's debt to GDP ratio is only 9%, the lowest in the G-20 world. Still, Bank Rossi cannot risk a policy of benign neglect towards the rouble at a time of stubbornly high inflation of +6.1%, and will need to hike interest rates aggressively in the year ahead, to contain capital flight.
India's central bank chief slams Fed's Tapering plans, - On Jan 31st, the Reserve Bank of India (RBI) chief Raghuram Rajan criticized the Fed's plan to withdraw from its QE-injections, saying that Tapering is threatening emerging markets. Since Sept, the RBI has hiked its overnight repo rate +75-bps higher to 8% today, in an effort to stabilize the Indian rupee. " International monetary cooperation has broken down," Rajan, told Bloomberg TV. "Industrial countries have to play a part in restoring that, and they cannot at this point wash their hands off and say we will do what we need to, and you do the adjustment you need to."
For the past three decades, the Indian economy has grown impressively, at an average annual rate of +6.4%. From 2002 to 2011, the average rate was +7.7% and India was closing in on China's growth rate. The economic potential of its vast population, expected to be the world's largest by the middle of the next decade, appeared to be unleashed. But India's self-confidence has been shaken. Growth in India's $1.6-trillion economy slowed to +4.4% last year; the India rupee was in free fall, and resulted in higher prices for imported goods. Consumer prices are accelerating at a +10% annualized rate, a dangerous situation for a country where one half of the population lives on less than $2 per day.
On Jan 28th, the RBI India hiked its overnight repo rate +25-bps to 8.00%, in order to clamp down on inflation, saying it was now better prepared to deal with the risk of major capital outflows roiling emerging currencies. The RBI said that if retail inflation eases as projected, it does not foresee further near-term monetary policy tightening. The US$ is +17% higher against the Indian rupee compared with a year ago, which in turn, triggered a sharp rise in India's 10-year government bond yield, to around 8.70% today, compared with as low as 7.25%, in the first week of May, when whispers of Tapering were first uttered.
For the RBI, which is seeking to keep the inflation genie firmly bottled up, much will depend on whether interest rates are high enough to stabilize or strengthen the rupee, as the Fed continues to pullback on its QE-injections. "We have to watch how this medicine works. We think we should be able to reach an +8% inflation rate by year's end. "Ultimately, the best way to create sustainable growth is by bringing down inflation," Rajan said. However, the RBI's rate hikes weren't the most effective weapon that knocked the US$ off its historic high of 69-rupees last summer, and into a range of 61-to-64-rupees today.
Instead, New Delhi moved in August to restrict the import of Gold into the country, a radical action to cut down the size of India's external deficits. Curbing the imports of Gold reduced India's current account deficit to $5.2-billion in the July - September period, compared with a shortfall of $21.8-billion in Q'2. India imports almost all of the Gold it consumes, and accounted for 20% of global demand in 2012. The RBI was also able to add $34-billion to its forex kitty by swapping rupees for US-dollars, with local banks, by paying them 3.5% interest, and helping to instill more confidence in the rupee.
Engine of World Growth Set for sharp Slowdown, It wasn't too long ago that Emerging markets were seen as the saviors of the global economy. In 2009, when the G-7 economies contracted by -3.5%, on average, the Emerging market economies, led by China and India, grew +3.1-percent. Emerging markets have expanded to become 55% of global economic output. So a prolonged slowdown in these countries will hurt the profitability of G-7 based Multi-Nationals, and has spooked investors in the global equities markets.
The wildfire engulfing the Emerging world is starting to revive memories of the past. The Tequila crisis in Mexico in 1994, the Asia debt crisis in 1997, the Russian debt default in 1998, the massive devaluation of Argentina's peso and Brazil's real, and the sub-prime debt crisis of 2007-08. The effects of the current storm will be felt beyond Emerging markets' borders. European banks have loaned in excess of $3-trillion to Emerging markets.
Emerging countries have much bigger stockpiles of foreign exchange reserves, but the sharp blows they have already received in the financial markets, if sustained, can inflict major damage on their economic activity in 2014. Furthermore, Emerging bond markets have grown to $10 - trillion, compared with $422 billion in 1993, and dwarfs the sums which fled in panic 15-years ago. Over $1.3 trillion now follows MSCI's main emerging equity index.
The Perma-Bulls in G-7 stock markets are rather sanguine about the latest market downturn. Very few are hitting the panic sell button. They're holding the view that the Fed will ride to the rescue with the Yellen Put, or the BoJ will expand its massive QE-operations to keep the stock markets afloat and climbing on their upward trajectories. But even centrists, like Atlanta Fed chief Dennis Lockhart, say despite the recent drop in the US-stock markets, the Fed won't be deterred from unwinding its QE-3 scheme. "Absent a marked adverse change in the outlook for the economy, I think it is reasonable to expect a progression of similar moves, with the asset purchase program completely wound down by the fourth quarter of the year," he said.
If the Tapering of QE is playing a role, it is merely shining a light on the structural deficiencies of "Fragile Seven" economies, which make-up 17% of global GDP. Most of the losses in the Emerging market currencies are expected to be sustained for a long time, and as a result, that would translate into less income for the G-7 Multi-Nationals that operate in those countries. Tapering will cause stiff headwinds for the aging Bull market on Wall Street this year . Markets have a long history of not focusing on problems until everybody decides to focus on the problem. This group-think means the volatility gets even bigger.
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