Summary

As mentioned in last month’s commentary, markets were overextended after the prolonged rally in the past few months, so the correction in June was overdue.  It is poignant to note that markets began to recover quickly towards the end of June as fear of rising interest rates started to abate.  However, it is equally important to note how sensitive markets are to interest rate rises.  This has major negative implications for financial markets when central banks want to start unwinding their quantitative easing programmes.  While central banks will prefer to let rates remain low for the time being and rise slowly in any economic recovery, the markets will likely react swiftly and sharply again to any interest rate rise, creating significant policy risk.  This also has major implications for the US dollar, especially versus emerging market currencies.  The global chase for yield led to emerging market debt and currencies becoming popular asset classes, leading to overvaluation of many emerging market currencies and financial markets.  A rising US dollar could cause the opposite to occur.

World tour of markets

June saw a dramatic collapse in equity markets after what had been their longest winning streak since the beginning of 2011.  The biggest news was confirmation from the Federal Reserve that it is considering tapering its QE3 quantitative easing programme. This programme has provided the ample liquidity that has fuelled the market rally since last November.  The world was also hit by news of a rapidly unwinding Chinese credit bubble and large popular protests in Brazil, Egypt and Turkey, all of which sapped market confidence.  The MSCI World Index fell sharply before recovering in the last week of June, when central banks reassured markets that they will maintain easy money policies, to end the month down -2.6% (still up +7.1% YTD).

The potential “Great Rotation” by investors from bonds into equities may have begun; in the least, fixed income investors are beginning to realise that the yield compression that has been so beneficial for their portfolios over the past 30 years may finally be coming to an end.  This was exemplified by PIMCO Total Return, the world’s largest fixed income mutual fund that suffered record redemptions of $9.9bn in June.  The yields on US Treasuries and German yields had some of their largest percentage jumps in recent history, up 16.8% and 14.8%, respectively, to 2.49% and 1.73%, respectively (although still well below historical levels).  Rising bond yields resulted in an abatement of inflation fears, causing the price of gold to suffer its second largest drop in recent history (after the largest drop in April); gold is now down -26.9% YTD and down more than one-third from its all-time high in 2011.  Brent oil was up +1.8% for the month due to fears that the protests in Egypt may spread to more of the Middle East, but in general, most commodities fell as slowing growth, particularly in China and India, has caused demand to drop off precipitously.

Market fears of a reversal of quantitative easing, rising developed market yields and the bias towards resources hurt sentiment in South African markets in June.  The JSE All-Share index was down -5.7%, although the rand was up +1.6% but still down -14.7% YTD.

The other major news in Africa was the mass protests against President Mohamed Morsi’s government in Egypt. It is refreshing that the Arab Spring in Egypt has focussed on the government’s poor provision of services and bad economic policies rather than pursuing a sectarian agenda.  Egypt’s market was down -12.3% for the month due to the instability, but rallied when Morsi was subsequently removed in July.
In Asia, the People’s Bank of China declined to inject liquidity into China’s financial system despite a rapidly slowing economy.  The central bank is trying to burst the credit bubble partially created by the massive stimulus measures and credit easing implemented in 2008.  Private debt levels in China are now at all-time highs.  Unfortunately, the lack of liquidity has resulted in a credit crunch, causing money market rates to more than double over the past two months.  The central bank had to reverse course in mid-June to stabilise the financial system.  Nevertheless, the Shanghai Composite was pummelled, down -14.0% in June, as the economy slowed much more quickly than the market had anticipated.  The government is intentionally causing a slowdown in investment to push the transition to greater consumption.  Unfortunately, this process is not easy and entails a lot of “policy” risk.

Further east, the Bank of Japan rattled investors by deciding not to unleash any fresh stimulus despite bond yields rising.  This followed on disappointing economic reforms announced by Prime Minister Shinzo Abe, which were much less bold than had been hoped.  However, the market seems to believe that there will be stronger reforms in July after the upper house parliamentary elections, which Abe’s party is expected to win.  After falling very sharply in May and early June, the Nikkei is now recovering, though it still ended June down -0.7% (but is up +31.6% YTD).

In India, the economy grew by 4.8% in the first quarter, far below government growth targets.  The fiscal year to 31st March had GDP growth of 5%, the slowest in a decade.  Nevertheless, the Indian market may be finding a bottom now, as price-earnings multiples are now down significantly and the Indian rupee has lost one-third of its value versus the US dollar since the beginning of 2011.  In a bad month for equity markets in general (and for emerging markets in particular), the SENSEX index was only down -1.8% in June and is roughly flat YTD.

Julia Gillard was ousted as Australia’s prime minister in favour of Kevin Rudd, who is the predecessor she had ousted in 2010.  Australia’s economy has slowed significantly as growth in the demand for Chinese commodities has declined.  The ASX 200 index was down -2.5% in June (+3.3% YTD), and the currency, which was previously heavily overvalued, has fallen by around 10% versus the US dollar since mid-April.

Russia posted an annualised growth rate of 1.6% for the first quarter of this year, compared to 3.6% in 2012 and a 7% average during much of the last decade.  The country lost 300 000 private sector jobs between 2008 and 2012 while the government added 1.1 million; the state now employs 18 million people (25% of the workforce, higher than France).  This has pushed the government into persistent budget deficits despite a commodities boom.  While the country could devalue its currency to make itself more competitive, this would likely drive the country’s already high inflation rate of 7.4% even higher.  The MICEX Index is the cheapest in the world and now even cheaper than Pakistan.

Further south, Turkish police attacked protestors in Istanbul’s Taksim Square who had been camping out to demonstrate against a heavy-handed government attempt to close a park and convert it into a commercial development.  Prime Minister Recep Erdogan has been in power for over ten years and implemented sound policies during that time that resulted in a dramatic improvement in Turkey’s economy.  However, Erdogan has become increasingly autocratic, and the protests have hurt sentiment; Turkey’s stock market was down -11.3% (and down -18.7% from its high in mid-May) and the lira currency lost -4.2% in June.

The European Union and the US agreed to start talks on a free trade agreement between the two economies in what would be the largest free trade pact since the Uruguay Round of the World Trade Organisation (WTO).  However, the deadline to complete negotiations in two years is ambitious, and the talks will aim to reduce tariffs and barriers on contentious goods and services, which had been excluded from previous trade initiatives.  The EU’s reform and financial healing process will continue to be difficult for the foreseeable future, and the rise in interest rates in June had a highly negative effect.  All major European markets were down significantly, with the FTSE 100, DAX 30 and CAC 40 down -5.6%, -4.7% and -5.3%, respectively.

In Latin America, Brazil scrapped a tax on foreign investment in bonds that had been implemented to staunch the flow of “hot” money, which had previously caused the real currency to appreciate.  However, the country’s economic slowdown is starting to cause unrest amongst a population, which has benefited from an economic boom stretching over 10 years.  Protests erupted across more than a dozen cities throughout the country as people took to the streets to demonstrate against a bus fare rise. Brazil has been consistently one of the poorest performing countries this year, with the Bovespa down -11.3% in June (and down -22.1% YTD) as the country fights a slowing economy, high inflation and a high current account deficit.

In the US, the most important news for the month was Federal Reserve Chairman Ben Bernanke indicating that the Fed will start tapering its quantitative easing programme in the fall of this year with the aim of stopping purchases by mid-2014 (although it will not sell the securities that it had previously bought).  Financial markets effectively fell off a cliff, with bond yields soaring and the S&P 500 down sharply; the damage spread globally, especially to emerging markets that had benefitted from loose monetary policy in developed countries.  However, economic data in the latter part of June generally came in under forecast; this had the perverse effect of causing a rally, as the market wagered that the Federal Reserve will have difficulty tapering quantitative easing while the economic recovery remained weak.  The Fed in any case clarified its remarks by saying that it still intends to continue with loose monetary policy through 2015.  As a result, markets recovered overall, and the S&P 500 was only down -1.5% for June.  The US dollar also appreciated against most currencies as the market repriced for higher yields in the US.  As the main economy where growth is actually accelerating, it is difficult to envisage the US market declining in the medium term.