The first two weeks of January 2015 were the worst for US equities since 1932, the height of the Great Depression. China’s stock market fell 10 per cent and sent shock waves across global risk assets, with Brent crude down to $34 and copper down to $4500 a metric tonne on the London Metal Exchange. The chaos in global markets did not subside and even after Shanghai regulators abandoned their flawed circuit breaker system and December US jobs rose 290,000, financial markets remain nervous about risk. The Chicago Volatility Index has almost doubled to 26 since its lows in 2014-15. The Japanese yen and the Swiss franc have attracted safe haven capital-as has gold and US Treasury bills.
Even though the US economy added 283,000 jobs a month since September and the unemployment rate has fallen to 5 per cent. Yet the world is haunted by deflation, not inflation risk, thanks to the free fall in crude oil and Chinese GDP growth rates. This is the reason why even though the Federal Reserve raised the Fed Funds rate in December, the ten year US Treasury note yield has fallen to 2.05 per cent. The bond market, like the Yellen Fed, is worried about the fallout from China’s $10.4tn economic supertanker’s hard landing and its 25 per cent public debt/GDP ratios, the biggest credit bubble in the history of world finance.
The weakness in Europe, Japan, China, the GCC, Africa, Canada, Australia, Brazil, Russia and Southeast Asia could well tip into history’s first “Made in China” global recession. The IMF has slashed its growth forecasts to 3 per cent. Commodity and oil capex could well fall by $1tn even as the Chinese Politburo has abandoned the yuan’s de facto dollar peg in favour of a high risk currency basket regime. So when the ECB, Bank of Japan or even the Reserve Bank of Australia print money to depreciate their currencies, the Chinese yuan also falls against the US dollar.
The Federal Reserve will not be able to raise the overnight borrowing rates if global economies tank, even if the US consumer, housing and banking credit markets are on a roll. The strength of the US job market and 19 million unit car sales alone will not be sufficient to cause a major rise in the US Treasury note yields to 3 per cent as long as the big chill from China continues.
Even though the US stock indices lost 8 per cent in the first two weeks of January, this does not mean the “Obama bull market” that saw the S&P 500 triple since 2009 is over. A geopolitical shock (North Korea’s hydrogen bomb test) and liquidity shock (the crisis in the high yield debt market, flawed policies in Shanghai, the ECB’s failure to deliver shock and awe monetary easing at its early December conclave) have all amplified the buy side angst on Wall Street. True, the Federal Reserve has begun the path of monetary normalization in December 2015. King Dollar and the energy/mining bust will also pressure US corporate earnings and profits. Even though the Fed rate hike was telegraphed by Janet Yellen to the capital markets, asset markets no longer have the tailwind of “easy money”. This means a rise in stock market volatility was inevitable even if China’s yuan had not fallen or the North Korean dictator not exploded his hydrogen bomb.
There is an essential linkage between Fed easy money, low volatility and valuations. When the VIX was 13 and the central bank is “quantitative easing” model, Wall Street bid up US equities to 17 times earnings. Now that the volatility has surged to 26 and short term US rates have begun to rise, US stocks are overvalued even at 15.4 times forward earnings if profits and margins disappoint. In fact, the August 2015 low of 1865 could even mark an optimal entry point for the next leg in the US stock market.
Asian equities have been the inevitable victims of the Fed rate hikes, the commodities bear markets, China’s hard landings and the global exodus from emerging markets. Asia ex Japan now trades at a modest 1.3 times book value and 10.8 times earnings, at least 30 per cent below its five year historic metrics. In fact, Asian equities have traded cheaper only during the 1997-98 currency meltdown, the Hong Kong SARS crisis in 2003 and the post Lehman global mayhem in 2008. Valuation alone is never a timing indicator. Price does not equate with value. Returns on equity in Asian equities have fallen from 18 per cent in the 1990s to only 10 per cent now. Asian currencies have been in free fall against the US dollar. Even the Singapore dollar, once viewed as the hard money Southeast Asian Swissie, has fallen to 1.43 against the US dollar as global trade and local property prices slump. Asian equities could well prove a value trap in 2016. Asian household and corporate debt presents a systemic risk to earnings growth even more than China.
Political risk also haunts Asian equities. Malaysia’s ringgit has plunged as Southeast Asia’s only oil and gas exporter has been rocked by a sovereign wealth fund scandal. Taiwan’s election could bring a pro-independence President to power in Beijing’s “renegade province”. South Korea’s relations with Pyongyang will deteriorate as long as its Dear Leader chooses nuclear brinkmanship. In fact, protests and purges in China could even trigger a Tiananmen Square nightmare for the Communist Party. Even India’s reformist Prime Minister Modi was defeated in a state election in Bihar.
The cheapest market in Asia? South Korea trades at book value and 9 times earnings. The most attractive economy in Asia? India, with 7 per cent plus GDP growth and the best demographics in Asia though a banking debt crisis and reform setbacks remain macro threat.