August initially saw an extension of the prior month’s gains made in developed market equities, with the S&P 500 index in the US hitting an all-time high, while the tech-heavy NASDAQ and some European markets like France’s CAC 40 index hit multi-year highs.  However, confirmation of further bailouts needed in peripheral European countries, a collapse in emerging market currency exchange rates and rising interest rates in the US and Europe caused the rally to peter out.  This was compounded by accusations that Syria’s government killed hundreds of people with chemical weapons.  The use of chemical weapons had been marked as the red line which would prompt a military response from Western powers.  The potential for military action saw the price of oil and gold rise and caused a sharp drop in equities near the end of the month.

Despite central bank efforts to calm investor fears of rising interest rates, the yields of developed market government bonds continued to rise.  US and German Bunds, which had reached record low yields last year, suffered the biggest yield increases.  US 10-year Treasury yields rose 7.9% to 2.78% (up +58.4% YTD), and German 10-year Bonds increased +11.1% to 1.86% (up +41.0% YTD).  This was a primary contributor to equity markets suffering a significant reversal of previous months’ gains, with the MSCI World index down -2.3%.  Most major developed markets declined, with the S&P 500, Nikkei 225, FTSE 100, and DAX 30 all suffering roughly 2-3% declines.

In contrast, positive economic data and increased buying of raw materials by China led to a significant improvement in sentiment in that country and a bounce back in commodity prices, which had declined substantially earlier in the year.  This benefited several commodity exporting countries like South Africa, Brazil, and Australia, all of which posted strong equity market gains.  Brent oil was up +5.9% (up +2.9% YTD), and gold was up +6.8% (still down -16.6% YTD) to recover some of the losses it has incurred over the course of this year.  Silver had the most dramatic move; after collapsing earlier in the year, it was up by around one quarter during the month.

In South Africa, auto manufacturing, construction and airport workers went on strike to demand higher wages, and gold mining workers have threatened to follow suit.  The National Union of Mineworkers which represents ninety thousand striking construction workers wants a 40% increase in wages and benefits, while employers are offering 7.5%.  International confidence in the African National Congress (ANC) has fallen dramatically, which compounded by anticipated Federal Reserve tapering, has led to further depreciation in the value of the rand currency.  Perversely, this has caused the stock market to hit a record high, with the JSE All-Share up +2.6% during the month (and up +9.5% YTD) as the effect of a recovery in commodity prices was heightened by further depreciation in the rand (which was down -3.4% versus the US dollar during the month and down -17.4% YTD).

Many other major emerging market countries have also been affected by the rapid withdrawal of foreign capital due to concerns of slowing growth and the Federal Reserve’s hinting of a tapering of quantitative easing, which is causing US interest rates to increase rapidly and the US dollar to rise substantially against emerging market currencies.  Sentiment towards emerging markets was also hurt by the Egyptian army’s bloody crackdown on the supporters of the recently ousted Islamist government that resulted in the deaths of around a thousand protesters.  Still, Egypt’s market seems to have stabilised to some extent with the EGX 30 index down only -1.1% for the month and -3.6% YTD; the military coup has proven to be popular with much of the citizenry.

In contrast, India had to impose capital controls on domestic investors and announce a ten point plan to reduce the country’s current account deficit in an attempt to arrest the depreciation in the rupee currency, which suffered its worst decline versus the US dollar since 1995.  India’s SENSEX 30 index was down -3.8% for the month and down -4.2% for the year.  Other major emerging market economies also reacted to the dollar’s strength.  Turkey hiked its interest rates to support the lira currency, which has lost around -10% vis-à-vis the dollar since the beginning of the year.  Brazil hiked interest rates for the fourth time since April (to 9%) and announced a $60bn intervention to counter the real currency’s decline to a four year low versus the dollar.  Brazil’s natural resource-heavy Bovespa index still benefited from a recovery in commodity prices, up +3.7% during August, but is still down -18.0% YTD.

Despite a slowing economy (second quarter GDP growth was +7.5% on an annualised basis, versus almost +10% in previous years), China’s financial markets seem to have stabilised in the recognition that the country’s economic transition should see growth at around +7%.  The Shanghai Composite index, after hitting lows last seen in 2008 during the world financial crisis, has been slowly recovering in recent months, in contrast to the significant falls in other emerging markets.  China’s Shanghai Composite index was up +5.2% for the month but is still down -7.5% YTD after a tough 2012.

Further east, the Japanese economy grew at a +2.6% annualised rate in the second quarter, which was below expectations given the significant amount of quantitative easing the Bank of Japan has enacted.  A potential increase in the sales tax, currently being debated in parliament, is increasingly being criticised as potentially dampening the country’s recovery even though it may be necessary to help reduce the government’s substantial fiscal deficit.  After enjoying the biggest advance of any developed market since late last year, Japan’s markets have stagnated since May and will likely require confirmation that Prime Minister Shinzo Abe’s reform policies are working before further increases are possible.  The Nikkei was down -2.0% in August but is still up +28.8% YTD.

In Europe, economic sentiment has rapidly improved (Germany posted an extremely high business confidence number) with the Eurozone economy expanding by +0.3% in the second quarter, led by Germany with +0.7% growth, France with +0.5% and Portugal surprisingly with +1.1%.  As a result, European banks, which are heavily tied to the sovereign risk of their home countries, have significantly outperformed the rest of the market.  However, the economic union is still facing a necessary third bailout of Greece (the International Monetary Fund estimates that an additional €11bn is needed), a political stalemate over reforms in Portugal, political scandals in Spain and Italy, and upcoming German parliamentary elections in September.  Standard & Poor’s downgrade of Italy’s credit rating to BBB (two notches above junk) highlights the urgency with which reforms need to continue.  All of these pose potential hurdles, though nothing as severe as the economic crises in 2010 and 2011.  The UK’s economy also seems to finally be healing, with industrial output up +1.2% year over year and the purchasing managers’ index hitting its highest level in 15 years.

What may pose a bigger hurdle, is the rapid rise in German and UK interest rates (in sympathy with rising US rates) as the European Central Bank and the Bank of England failed to convince markets of their commitment to maintaining low rates until a European economic recovery is stronger.  Though spreads between peripheral Eurozone countries and Germany are now close to their narrowest since the last economic crisis in 2011 (Italian 10-year bond spreads over German Bunds was down to about 227 basis points from a record 575 bps in November 2011), this is partly due to German rates rising with 10-year Bunds almost reaching 2% after being as low as 1.17% last November.  Still, European markets have been gradually outperforming US markets in recent months; Germany’s DAX 30, France’s CAC 40, and the UK’s FTSE 100 were down -2.1%, -1.5%, and -3.1%, respectively, during the month and up +6.4%, +8.0%, and +8.7%, respectively, YTD.

In the US, the Federal Reserve is expected to start cutting its QE3 quantitative easing programme, which consists of $85bn in bond purchases monthly, at its mid-September meeting.  Initial talk of “tapering” quantitative easing caused a significant market reversal in May and June, though US and European markets have recovered since then.  However, raised interest rate expectations from the tapering talk and a potential attack on Syria resulted in the S&P 500 index being down -3.1% in August, though the market is still up +14.5% YTD. Surprisingly, government bond markets have already largely priced in the expected medium-term move in interest rates, with US government bond yields surging in recent months.  US 10-year Treasuries are approaching 3%, almost double what they were at the start of the year, and US government bonds have been one of the worst performing asset classes in the US this year.

September will be filled with major economic and political events.  The Federal Reserve will decide on the quantity and speed of tapering quantitative easing, Germany will have parliamentary elections, potential military action may occur against Syria, and the US Congress will need to pass a fiscal budget and raise the debt ceiling. Central banks know they will have to keep rates relatively low for the foreseeable future, so the Federal Reserve is likely to be moderate in its adjustments to quantitative easing.  Polls in German elections seem to indicate that the present government will return to power.  This bodes well for the Eurozone, as many issues, such as further bailouts of peripheral countries, have been pushed back until after these elections.  The upcoming budgetary and debt ceiling battle in the US Congress has repeatedly failed to produce a useful long-term resolution to the US government’s short-term and long-term fiscal issues.  Both sides are digging into their positions, and it is difficult to predict whether a compromise will be reached without causing market turmoil.

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