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Report prepared by: Ryan Lewenza, CFA, CMT North American Equity Strategist
Global equity markets have started the year on a negative note, with the S&P 500 Index (S&P 500), MSCI Europe Australasia Far East (EAFE), and MSCI Emerging Markets (EM) indices down 3.6%, 4.1%, and 6.4%, respectively, during the month of January. The weakness across the global equity markets can largely be attributed to: 1) softer economic data which points to weakening global economic momentum; and 2) the U.S. Federal Reserve s (Fed) move to reduce its asset purchases by an additional US$10 billion per month. The recent stock market rout was triggered by the January HSBC Flash China Purchasing Managers Index (PMI) which showed a contraction in the Chinese manufacturing sector. That coincided with the high for the S&P 500, with the index declining 20 points the following trading day. With the Fed cutting back on its asset purchases, the unprecedented liquidity that flowed into risky assets, such as the EMs, is now being withdrawn, resulting in steep declines of some EM currencies. The question then is whether the instability in the EMs will escalate and lead to a global contagion, similar to the 1997 Asian currency crisis. We believe this scenario is unlikely, and that as the markets acclimate to reduced Fed liquidity, the EMs will begin to stabilize. The U.S. economy has lost some momentum following a strong H2/13. However, we believe U.S. economic data could trough soon, possibly over the Spring/Summer. The upside of the recent equity market weakness is that equity valuations and investor sentiment have corrected from their elevated levels in Q4/13.
This Document is for distribution to Canadian clients only. Please refer to Appendix A of this report for important disclosure information.
February 6, 2014
QE1
QE3 QE2
40% 0%
-40% Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Source: Bloomberg Finance L.P. As of January 31, 2014
Jan-13
Jan-14
Some of the money created from the Feds QE programs made its way into the EMs, where interest rates were higher. Now, some of this is being reversed, as investors sell EM assets (stocks and bonds) and repatriate funds to the U.S. Countries with large current account deficits are particularly vulnerable, as they require foreign capital to fund their deficits (Exhibit 2). With the Fed cutting back on its asset purchases, the unprecedented liquidity that flowed into risky assets, such as the EMs, is now leaving these regions, resulting in steep declines for some EM currencies. The Argentine Peso and Turkish Lira have been hit particularly hard, declining 18% and 6%, respectively in January. The question then is whether the instability in the EMs will escalate and lead to a global contagion, similar to the 1997 Asian currency crisis. We believe this scenario is unlikely, and that as the capital markets acclimate to reduced Fed liquidity, the EMs will begin to stabilize. Moreover, growth in the developed markets should help to offset weakness from the EM countries. Exhibit 2: EM Countries with Current Account Deficits and Their Respective Currencies Movements
EM Current Account Deficits As % of GDP
0 -1 -2 -3 -4 -5 -6 -7 -8 -7.2 -4.4 -3.6 -3.7 -0.7
5%
0%
-5% -10% -15% -20% 31-Dec
Brazilian Real Per USD Indian Rupee Per USD Turkish Lira Per USD Argentine Peso Per USD
6-Jan 12-Jan 18-Jan 24-Jan 30-Jan
Turkey
India
Brazil
Indonesia
Argentina
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The U.S. economy has lost some momentum following a strong H2/13 in which U.S. GDP grew 4.1% and 3.2% for Q3 and Q4, respectively (Exhibit 3). Nonfarm payrolls were extremely weak in December with just 74,000 jobs created in the month. The ISM manufacturing report released this week captured the deceleration in economic activity, with the headline index declining 5 points to 51.3 and the leading new orders sub-index slumping 13 points to 51.2. This follows softer U.S. housing data, which points to a pause in the housing recovery after the spike in mortgage rates in H2/13. Despite this we believe U.S. economic data could trough soon, possibly over the Spring/Summer period. We highlight the U.S. Citigroup Economic Surprise Index, which captures economic releases relative to their expectations. Over the last few years this index has fairly consistently peaked in Q4, declined in Q1, and then bottomed in Q2/Q3 (Spring/Summer). We believe this pattern could be repeated again this year. In addition, the extreme cold temperatures and winter storms experienced across most of the U.S. and Canada has likely impacted economic activity. While we are reluctant to use the weatherrelated excuse to explain the recent weakness in economic data, the U.S. did experience its coldest January since 1994, which we would expect to crimp consumer spending and economic activity. As such, we could see a rebound in spending and activity once the polar vortex has passed. In sum, we see the potential for a reacceleration in the coming months, and therefore do not believe the unfolding EM stresses will derail the U.S. economic recovery. Exhibit 3: Strong U.S. Economic Activity Seen in H2/13 Could Re-emerge in the Spring/Summer
The upside of the recent equity market weakness is that equity valuations and investor sentiment have corrected from elevated levels. The S&P 500 forward P/E has declined over a full point, from 16.7x in late December to 15.5x currently (Exhibit 4). Towards the end of 2013 it was difficult to find high-quality companies at attractive valuations; however, following the pullback we are finding a lot more attractively valued stocks. Looking at investor sentiment, many of our sentiment indicators were at extreme bullish readings at the end of 2013, which led to some short-term concerns for us. Looking at the Individual Investors sentiment poll, 55% of investors polled in late December were bullish (just 18% were bearish), which is an extreme reading, and well above the long-term average of 39%. As of last week, this sentiment reading was at 32% and approaching levels where sentiment typically bottoms. From a technical perspective, we believe there is the potential for additional near-term weakness, with the S&P 500 possibly declining to its 200-day moving average (MA), currently 1,709. If correct, we would expect investor sentiment to turn increasingly bearish, possibly setting the stage for an end to the pullback. Exhibit 4: S&P 500 P/E Has Declined 1x to 15.5x; Bullish Investor Sentiment has Corrected from Elevated Levels
S&P 500 Forward P/E
18 17 16 15 14 13 12 11 Jan-10 Jul-10 Jan-11 Jul-11 Jan-12 Jul-12 Jan-13 Jul-13 Jan-14
Source: Thomson Reuters Datastream. As of January 31, 2014
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Conclusion The global capital markets are adjusting to a more normalized Fed monetary policy as the Fed slowly reduces its asset purchases. During these periods, equity markets typically come under short-term pressure as investors begin to price in less accommodative monetary policy. In our 2014 Investment Outlook we suggested that the equity markets could encounter increased volatility in Q1/14 around this event, but that North American equities could still post positive returns for 2014 on the back of stronger earnings growth. This remains our view. We believe the current EM concerns will subside and that the U.S. economy could improve in the Spring/Summer timeframe providing the foundation for equity markets to climb higher in H2/14.
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