Fight, flight or freeze response to global capital markets

Greece’s debt problem can rattle the European Union at any time. Commodity prices and inflation are low, as the world economy is slowing down, and so on and so forth. 

The mood of market is decidedly “risk off”. 

If you ask me, “What we should do now? Just be warned? Rebalance the portfolio? Or stay away from the markets?” my view is that we should understand all those trends before making any decision.

First, everything connects to commodities and interest rates. From the very beginning, weaker demand in many emerging countries, including China, and surging US fuel production have pushed the oil price down. 

Falling fuel prices do not affect only them but also trigger falling prices of crops that can be used for alternative energy. This has created a further downside to the world economy and has pushed energy exporters, such as Brazil and Russia, into recession. 

How can a country fight low commodity prices and recessionary conditions? 

The easiest way is to ease its internal financial condition. A lower interest rate or quantitative easing can be used to boost the economy. 

Nevertheless, monetary-easing measures are useable if only you can fully control most debts and the currency market. Only a small number of closed economies in the world can do that. 

Making things even harder this time, higher US interest rates will stab dollar debt-holders who are trying to fight with a recession at their back. As US rates get higher, their currencies will depreciate against the dollar, and their debts will become larger. Afterwards, financial assets in non-US countries will suffer from foreign investors’ sell-offs after losing their value because of relative currency performances and economic outlooks. 

Needless to say, this also creates market volatility. 

China’s stock market is a very good example. China’s economic slowdown is one factor but the expected US interest-rate increase is a catalyst for the sell-off by foreign investors that made China’s boom turn to bust, which created higher volatility in the market. 

Consequently, fluctuations led investors to require higher returns from their investments to maintain their risk/reward ratio. Thus a further sell-off in markets and slower business activities in problematic countries are expected as a virtuous circle.

In summary, if markets behave as per financial theory, we should see the US dollar outperforming in currency and commodity markets, equities in developed markets performing better than equities in emerging markets, high-yield bonds doing better than high-grade bonds, and a growth strategy, excluding commodities, winning against value investing. 

What is really happening so far?

On a relative basis, the winning long-short trades since the beginning of this year can be illuminated. Long US dollar and short industrial material has yielded 14 per cent, while long Japan over Brazil equity has returned almost 43 per cent. 

Regarding growth versus value, healthcare over industrials and consumer sectors over resources are the undeniable winning trades of this year. In the US bond market, high-yield bonds over Treasury trades also yielded 4.4 per cent.

Would those strong patterns that I showed lead you think twice about your decision? 

Actually, they are nothing to us unless the trends are here to stay. 

In my point of view, it is just the beginning of a cycle. 

This is the third time since 1970 that the world of finance has experienced this kind of event, US-dollar bulls and emerging-market bears. 

The very first one was from 1980-87 with the Volcker shock, the Latin American crisis and the Plaza Accord. The second one took place around 1994-2001 with the China devaluation, the “tequila crisis”, and the Long-Term Capital Management event happened. 

In summary, history tells us that this kind of trend generally takes some time before it reverses. 

However, like every trend, I do think that the market cannot and will not stay in only one direction for too long. 

Though I think it will take more than three years for the United States to bring its interest rates to their expected level, I also expect it would not go on a smooth and sound path.

Many investors prefer a consistent strategy that focuses on limited investment guidelines because it takes less time and effort, such as local, high-quality firms and high-dividend yields. 

Yet ignorance of big trends is not a good idea in my point of view. Thus I remind you of the fact that what we really have is the right to control our actions, not the right to control the result. 

Fight, flight or freeze to global capital markets? You have the full right to choose.

 

Jitipol Puksamatanan, capital market economist at TMB Analytics, the economic analysis unit of TMB Bank, can be reached at [email protected]