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Market Malaise
Toronto: February 10, 2014
By John Stephenson

The stock market has been in quite a funk these last few weeks, as worries over the fate of emerging markets has turned markets and currencies on their heads.  Expectations for a reduction in stimulus from the Federal Reserve, weak economic data in the U.S., coupled with slowing Chinese growth and other problems with specific developing countries, triggered a massive wave of selling in emerging markets earlier this year. Since April of 2013, the currencies of Brazil, South Africa, Indonesia and Turkey have declined by more than 15% and the MSCI Emerging Market Index has trailed the S&P 500 by more than 23%.
A dismal U.S. employment report out this past Friday added to concerns that momentum in the world’s biggest economy may be slowing.  Non-farm payrolls rose by 113,000 last month, which while an improvement on December’s numbers was much less than expected.  The only bright light in the report was that the jobless rate slipped from 6.7% to 6.6%.  In spite of the gloomy employment report, global equities managed to rally to close the week.

But the problems in the emerging markets are widespread.  The Argentinian peso has been devalued.  Strong growth in Brazil has waned, and the Turkish lira has plummeted.  In South Africa, an ailing economy is mired in miners’ unrest, and in China growth is endangering commodity exporters that have ridden the cyclical boom. The common denominator for much of this malaise is the removal of stimulus by the Fed—a move that will boost U.S. yields and attract investment flows from abroad. 

As things turned sour, India’s central bank was the first to react by boosting rates in an attempt to stem the flow of investment dollars out of the country.  Then Turkey reacted, followed swiftly by South Africa.  One by one, central banks of fragile emerging markets raised their benchmark interest rates as capital outflows from emerging market debt and equities reached $9.1 billion.

Already, the chaos in emerging markets has wiped $1.7 trillion off of global stocks, hurting investors and forcing a re-examination of emerging markets, which appear to be wobbling badly, endangering global growth.  

For some, the problems with the emerging markets are reminiscent of the 1997/1998 Asian Crisis that began with a slide in the Thai baht, but quickly managed to spread to the entire region, driving global markets into a prolonged tailspin.  While there are many similarities between the 1997/1998 and the problems of today, there are many important differences.  In 1997, countries at the heart of the trouble mostly had fixed exchange rates, little to no foreign currency reserves, and had coasted on a credit boom that fuelled bad loans and papered over the lack of meaningful reforms.

Today, the current troubles in the emerging markets are remarkably uneven.  In India, slowing growth is laying bare government economic reforms yet to be implemented.  In Argentina, economists are fretting that a decade of economic mismanagement and a hastily devalued currency may precipitate a recession.  And in South Africa, falling commodity prices have slammed mining companies leading to violent protests.
With worries over the health of emerging markets spilling over into developed markets, the S&P 500 slumped more than five percent from its record high, with the skeptics out in full force declaring a doomsday scenario for Western markets.  But despite the volatility in markets, I for one remain optimistic about the prospects for the S&P 500 this year.

The yield curve, an important predictor of U.S. recessions remains steep and has actually steepened in recent months.  If the yield curve had narrowed appreciably or become inverted, this might be a worrisome sign, since a significant narrowing or inversion of the yield curve has preceded every U.S. recession in the post-war period.  As well, investor euphoria remains in the dog house, with high beta stocks struggling to get a bid.  Low beta stocks are the ones that remain expensive, suggesting a flight to safety rather than momentum traders trying to ride a bullish wave. 

While the uncertainty in the market is unsettling, it is to be expected.  The market is transition from a macro driven “risk on/risk off” framework to one in which individual stock fundamentals are paramount.  I for one am using the recent pullback as an opportunity to continue to build positions in my favorite names.

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