Global Markets Crash Confirms Our Long-Held Views
We have long expected the US equity market to crash, owing to a combination of extreme valuations and deteriorating market internals, so regular readers will be aware that recent events are not a surprise (see 'Profit Squeeze Points To Major Market Top', June 5; 'Maintaining Conviction Calls, US Stocks Next Card To Fall', July 16; and 'Support Broken, Crash Risks Rising', August 21). We continue to believe that US equities and mainland Chinese equities are the most precarious markets globally, and we expect further declines over the coming weeks and months. The potential for a more dovish Fed, however, could provide some relief to Emerging Market (EM) stocks outside of China.
Why Are Global Markets Crashing?
While investors look around for a 'smoking gun' to explain the severe decline in global stocks, we believe that the rout was an inevitable result of artificially inflated markets driven by monetary stimulus, which has been unable to stave off weakness in global economic growth and deflationary pressures. Our expectations for a market crash was driven by a combination of excessive valuations and deteriorating market momentum, rather than any expectation of an adverse external shock.
Global financial markets, and in particular the US and China, had been driven to unsustainable levels as investors believed that easy monetary policy could prevent a market crash and that low yields on cash and bonds justified extremely high prices. As such, like a house of cards, markets were (and still are) unstable, and it is immaterial to focus on the card that actually 'triggered' the collapse. While the fall in Chinese stocks is being widely blamed, the MSCI China index is down one third from its peak, with the first 20% fall from the peak having had little impact on US stocks. Black Monday of 1987 was said to have been triggered by a weaker-than-expected US trade figure, but if that hadn't been the trigger, something else would have.
US: Stocks Still Expensive And Chart Damage Done
From a short-term perspective, we cannot rule out a strong relief rally in US stocks, but note that it would likely be regarded as a bear market rally in hindsight. Likewise, we cannot rule out a continued rout that takes the S&P500 down to 1,500 in short order, at which point the valuation excesses would be at least partially unwound. Our main message here, though, is that US stocks are still extremely expensive despite the recent decline, and have seen major chart damage that should give way to further weakness over the coming weeks and months.
It also seems likely that the US Fed will adopt a more dovish tone, which should undermine the US dollar and support bonds (see 'Hiking Cycle Not A Done Deal', August 12). Already, we have seen the USD weaken considerably against the euro, and further euro gains look likely. The yen has also re-emerged as a global safe haven. We are also seeing some potential for the USD to finally weaken against EM FX, which has taken a beating in recent months and is looking very oversold.
Europe: More Insulated Due To Cheaper Valuations
We continue to expect the US to underperform the rest of the developed world, owing largely to its more expensive valuations. The US is trading at extremes relative to the MSCI Europe Index as well as the MSCI UK Index, and there is much less air to come out of the latter markets.
China: Mainland Stocks And Yuan Face Further Downside
The rout in mainland Chinese stocks (A-shares) has further to go, in our view. As we argued previously (see 'Beijing Must Choose Between Supporting CNY Or Stocks', August 19), Beijing will increasingly have to choose between propping up the equity market and defending the currency from further downside pressure. They will not be able to do both. Both the local stock market and the currency are significantly overvalued, and the veil of government support for both markets has been pierced, giving way to free market forces. We continue to expect lower equity prices and continued weakness in the yuan.
Emerging Markets: Excluding China, Outperformance Increasingly Likely
With the exception of mainland Chinese stocks and some other smaller markets such as the Philippines, towards which we remain bearish, the outlook for EM stocks is looking up. That is not to say that they will stage an immediate recovery, but there is a growing bullish case to be made from a relative value perspective. Sentiment is extremely bearish and bordering on capitulation. Valuations in markets such as South Korea, Brazil, and Russia are very cheap. The sell-off has seen markets become extremely oversold, with the relative strength index (RSI) on the SPDR Emerging Market Dividend Opportunities Index at just 9.4, the lowest on record. The dividend yield on the index, meanwhile, has shot up to an attractive 6.4%. If the Fed remains on hold and US bond yields head lower, this would provide some support to heavily indebted EM corporates, creating the conditions for EM stocks excluding mainland China to outperform.
Editor's note: This was adapted from a subscription article published the same day. The full article includes charts of the relevant markets, and our Global Asset Class Strategy table.