Since the beginning of the New Year, the world equity markets lost nearly $6.5 trillion in value. That is nearly a 10% loss for a global equity market that is worth nearly $70 trillion in market cap. It is not often that you get to see this kind of value destruction globally in such a short period of time. The carnage was not just restricted to the emerging markets. It spread across commodity and banking stocks; across technology and pharma stocks; across developed and emerging markets as well as across mid-cap and large cap companies. What were the prime reasons for this market panic and what does it bode for the year 2016?
Oil is the primary concern…
Crude oil is getting perilously close to the level predicted by the likes of Goldman and Citigroup at $20/bbl. During the week, oil prices remained below the $30/bbl mark for most part. This is negative for market sentiments for three reasons. Firstly, it is a clear indication that there is a distinct slowdown in demand, especially in China, which is the largest consumer of oil in the world today. That is not great news for countries depending on Chinese exports to prop up their economy. And the list of such nations is quite long and all-encompassing. Secondly, weak oil prices will mean that the OPEC countries plus others like Russia and Norway will continue to bleed and keep drawing down on their petrodollars to balance their budget deficits. That will mean more selling in the equity and bond markets. Already, J P Morgan has estimated that the oil SWFs are likely to sell assets worth $250 billion this year, which includes $110 worth of bonds and $75 billion worth of equities. Neither of these markets has the capacity to absorb this kind of supply.
Thirdly, oil is in a Catch-22 situation. They need to produce more oil to cover up for the lower price and this higher production is leading to oversupply and stockpiling. The world is sitting on 3 billion barrels of stockpiles and is running out of storage space. That means pressure on oil prices will continue in the foreseeable future. Weak oil prices were one of the primary reasons driving the global markets lower.
There is a global risk-off trade away from equities…
What we saw in 2016 is not just a risk-off trade away from emerging markets in favour of developed markets. It was a more macro risk-off trade where investors were moving away en masse from equities and staying in the safety of debt. Even gold suddenly emerged as a safe-haven investment in these tumultuous times and the precious metal managed to take support around the $1050/oz and rally upward. The global risk-off is very evident when one looks at the FII activity in equities in India over the last 10 days. They have been consistently selling nearly $200-250 million worth of equities on a daily basis, which reflects a systematic shift out of risk-on and into risk-off. This risk-off trade arises from two key concerns in the current equity market.
Firstly, most investors believe that the stock market rally in the last few years was largely driven by liquidity infusion from central banks. To a large extent they are correct. When the US decides to start hiking rates and demonstrates its seriousness in December last year, then it becomes a matter of real concern. As liquidity vanishes from the markets, the premium that stocks commanded due to the asset inflation argument is likely to eventually compress and vanish altogether. That means equities across the world could be in for a serious return to normalcy in valuations. Secondly, if the US continues with its rate hike program, then the monetary divergence could make equities a lot more volatile. That will obviously drive money into bonds and even into safe haven commodities like gold and silver.
Currencies played a big part in the correction…
This is in a way related to the previous point. Weak currencies were a major issue during the New Year. Since the beginning of January, most of the global currencies have lost value against the US dollar. This can be partially an outcome of weak commodity prices and partially an outcome of FII outflows. When currencies weaken, the FII money typically tends to gravitate towards the US dollar or even the Euro or Yen where the risk of large scale currency devaluation does not exist. In fact, in the last few weeks, there was a general preference among fund managers to allocate funds even to EU and Japan as a safe-haven investment.
As India saw in 2013, in the event of a weak currency, FIIs prefer to wait on the sidelines and re-enter the markets after the currency stabilizes at lower levels so that their portfolio dollar returns do not get hit negatively.
And finally, you cannot forget China…
Any correction of this scale has to do with China and this time it is no different. China has already seen its GDP growth slowdown from above 10% to 6.8%. With China’s much talked about opacity in numbers, analysts believe that even this could be a gross overstatement. In fact, global investors like Marc Faber stick their neck out to project that China may actually be growing at just about 2-4% annually. It is this opacity in data that adds to the Chinese conundrum. China is important because it is the largest factory and the largest consumer in the world. A slowing China means weaker demand for everything from steel to cement to cars to luxury items. That is bad news for the world economy which is already showing signs of tiring. Recent Markit PMI numbers of Chinese manufacturing have come in at round 48 which betray a distinct contraction in manufacturing. China was the engine of global growth since the last 8 years and a reversal in China means a reversal in the entire post-2008 story of global markets. That is slightly disconcerting.
In a nutshell, there may be too many questions and too few answers. Global markets are surely in a dilemma and China, oil and currencies have only compounded the problem. What we saw in January was the first reaction to these 3 factors impacting the global economy. Of course, the US decision to hike Fed rates was the tipping point. What happens in 2016 will be largely contingent on how the Fed deals with rates going ahead. That remains the trillion dollar question!
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