Summary: One often hears the refrain “the market is not the economy”, but what does that really mean? I am going to explain it in my terms here in the context of the global reflation trade – EM meltdown paradox.
As I wrote yesterday, my view is still that the global economy is in reflation/recovery mode. All of the major developed markets have better numbers from the US to Europe to Japan. And China also seems to be in reflation mode despite the desire of the Chinese government for rebalancing. To me, this means a improving global economic growth.
Yet, at the same time, the emerging markets are getting hit hard and I believe this owes to two factors. First, as markets anticipate the unwind of QE, liquidity is leaving EM, which was overbought due to easy money leaving the developed markets for EM in the currency wars . Second, China’s rebalancing, while uneven, is still crushing the commodities cycle and therefore negatively afecting the real economy in commodity-dependent emerging markets.
But, that is mostly about the real economy and not the stock market. In equity markets, EM is also taking it on the chin – rightfully so. But what about the spillover into other markets. We see a lot of EM currency volatility. But, thus far, we see no real discernible impact on markets in the developed economies from the EM meltdown. My concern here is that we will see this impact and the fact that that we are ripe for a major correction in the US makes this an even more precarious situation.
To the degree the Fed’s QE unwind is behind the volatility in the emerging markets, we should think of what is happening as an incipient move to risk off, with EM feeling the pain first. Other risk assets will also feel the pain in due course as rates in the US and Europe have backed up a lot in the past few months. I believe that the confluence of higher rates, market volatility, and lower earnings in the US spells risk-off for now. The US market’s advance has been predicated on multiple expansion. This is in large part due to discount rates coming down. In the past year, earnings have gone lower yet the positive sentiment from QE-fuelled risk-on plays have allowed multiple expansion to overcome the lower earnings and keep stocks at elevated levels. In my view lower earnings and higher rates in a background of increased volatility spells risk off.
This explains why despite my fairly bullish real economy view, I am not as bullish on shares.