- Potent cocktail of China, EM and commodity fears leads to market rout
- The Chinese authorities are likely to ease policy soon – other central banks will wait and see for now
- Market turmoil can undermine confidence, but macro positives are still out there
Global equity markets…a sea of red
The potent cocktail of China, emerging market and commodity fears escalated sharply on Monday. The late losses on equity markets in the US on Friday and the lack of action by the Chinese authorities over the weekend did not bode well for the market opening. Chinese and Asian stock markets plunged on Monday and the European, and subsequently the US markets, followed. The VIX surged and credit spreads widened.
Flight to safety
The deterioration resulted in a general flight to safe haven assets. The Japanese yen was the clear outperformer in currency markets. Furthermore, US Treasury yields fell, with the 10-y dropping below the 2%-mark, though Bunds did not benefit, with yields flattish.
EM and commo weakness
Emerging market and commodity currencies showed substantial losses mirroring the price sell-off in commodity prices. What surprised some commentators is that gold prices did not rally sharply. This confirms our view that its safe haven status is undermined by speculative long positions in the metal.
Dollar weakness now, gains only in real panic
Meanwhile, the euro saw a stunning rally against the dollar. This reflects the closing of euro short positions used to fund carry trades. In addition, the dollar was hurt because of the pricing out of Fed rate hikes this year. However, if there were to be a further escalation of market turmoil towards a real panic, there would be a strong dollar rebound as investors swarm to the most liquid assets.
Questions on policy reaction and growth
The deterioration in market sentiment and escalation of worries about China and emerging markets raise questions about what policymakers will do in China itself and elsewhere, and the impact on global growth.
The heat of the moment
It is always dangerous to draw strong conclusions during the heat of such aggressive market corrections, where the outlook can look so bleak. However, we will try and take a step back and make a number of observations below.
China will ease sooner rather than later
We do not think that the Chinese authorities are waving the white flag in terms of supporting economic growth. Their aim in our view remains to foster a gradual slowdown and signs that momentum is deteriorating more sharply has always triggered action to support the economy. They also have a lot of ammunition they can fire. We expect the authorities to take further steps sooner rather than later. Some combination of reductions in bank reserve requirements, policy rate cuts, fiscal stimulus and further moderate yuan depreciation will be rolled out in the coming time.
Other central banks will wait and see
The heightened market turmoil – which if sustained could hurt global business and consumer confidence – and growth risks in China and emerging markets also increase the chances of more accommodative stances by the big central banks. The Fed could delay rate hikes and the ECB could step up QE, for instance. But this is not our base case and we think it is too early to go in this direction. Central bankers will take a wait and see stance to get a better picture of the situation before deciding.
Macro positives – yes positives – are still out there
The US economy has been gaining momentum recently, while eurozone growth has been resilient after firming earlier in the year. Even in China, the data have not been all bad, with signs of improvement in June before July’s deterioration. In addition, monetary conditions in China eased in July, reversing the tightening seen earlier in the year. Finally, Fed hikes would be a negative for emerging markets, but any rate hike cycle is likely to be very slow given subdued inflationary pressures.