ALERT! Market Volatility Update -The Macro Environment

Paul Morrone |

Recent headlines have been quick to report a global sell off in equity securities. While there are many variables seeking to disrupt capital markets, only a handful may be attributed to the significance of the recent pullback in asset pricing.

The three fears most aggressively permeating equity markets have resulted in the tightest range of returns for the S&P 500 in the last 50 years:

1. The Greek monetary crisis and ensuing dismantle of the Euro Area. Greece, after defaulting on their loan to the International Monetary Fund, has accepted more pronounced austerity measures in their debt servicing. They have received emergency liquidity, and for the moment, the uncertainty of European dissolution has largely dissipated.

2. Prominent fears of interest rate normalization. Investors are concerned with a premature interest rate hike by the Fed that could potentially drive the economy into a relapsed recession. The Fed has reiterated however that the path to interest rate normalization will be of greater concern to capital markets than the timing and magnitude of the first rate hike. Equity securities on average have appreciated near 10% during the first 12 months of an interest rate hike, similarly bull markets do not dissipate for two and a half years after such an event.

3. The correction within Chinese equity pricing and deceleration of domestic production will put greater deflationary pressures on commodity pricing, which may be indicative of a global collapse in equity markets. The Purchasing Manager’s Index (PMI) which indicates contraction or expansion within industrial production and services of an economy has signaled growth not only within developed nations – but also in that of Chinese and emerging markets. (World PMI; 53.4, EU PMI; 54.5, U.S. PMI; 55.7, China PMI; 50.2, EM PMI; 50.2. A value greater than 50 indicates expansion while a value below depicts contraction.)

The Chinese government has begun a fundamental transition from that of an economy based on foreign investment, to that based on domestic consumption. As a result, more transparency is needed in capital markets and thus shadow-lending among central banks and government sponsored agencies has been greatly reduced. This government mandate has essentially curtailed liquidity and currency velocity within the region, leading to the most recent correction among Chinese equity pricing. The correction however was not a collapse in that the Chinese stock market has vastly out performed any other such market and is due for a pullback directly in line with the changing dynamics of capital flows.

The collapse in commodity prices may be explained as a result of the slowdown in Chinese domestic production, leading to a devaluation of their currency to boost exports in an attempt to reach the government mandated level of economic growth. As a result, many periphery nations and respective currencies saw an excessive debasement of their local currencies, essentially decreasing the buying power of these import heavy economies. This further depresses the global demand for commodity use and places a debilitating pressure on respective asset prices. Such pressures are cause for concern for foreign investors; and without aforementioned market transparency, capital flight manifests has a consensual collapse in emerging markets equities.
This reiterates the notion that short-term fear trumps market fundamentals while most directly referencing the Taper Tantrum of 2013. Capital flight from emerging markets is akin to interest rate normalization within the U.S. economy; this is because many currencies representing developing nations are dependent upon the cost of the U.S. dollar. Without dollar-denominated currency to support developing markets, equity pricing depreciates in direct relation to the local currency.

Thus despite improving conditions across developed economies, regional panic-selling may spillover and result in a significant drawdown of domestic equity prices. From a historical perspective, this is well within the realm of appropriation as 5% pricing corrections occur on average 3.3 times per year, for the last 80 years – with a correction of 10% occurring once every 14-15 months.

Although the fundamentals and economic conditions remain favorable for developed market equities, the technical metric of price momentum breaching two and a half percent below the 200 day moving average of the S&P 500 is a historical indicator of a change in market trends, and has been effectively triggered. While the technical fluidity of capital flows indicate a change in price trends, it is important to note that certain fear barometers have not been flagged. When looking at market fundamentals, the VIX Volatility Index is relatively subdued in comparison to the crisis of 2008; likewise the spread between the two and 10 year bond yield has not contracted. When view in aggregate, the technical change in price momentum absent of deteriorating fundamentals is conclusive of a short-term sell off and not a recessionary economic state. This leads us to postpone any aggressive transition with respective portfolios, and as we continue our research through the week we shall make formal recommendations.