January saw equity markets suffer their worst reversal since the market volatility in May and June of last year, caused by the US Federal Reserve’s indications of tapering quantitative easing.  Markets initially sustained their levels from December for the first half of the month on the back of a rally that made 2013 the best performing year since 2009 for most developed markets as well as certain emerging market countries such as Nigeria and South Africa. However, markets pulled back sharply in the second half of January.  Profit-taking, slowing growth and increased financial stress in emerging markets, and further reduction in quantitative easing by the Federal Reserve (by another $10bn to $65bn after a previous $10bn cut in December) all contributed to the decline.  The MSCI World index was down -3.8% for the month, with most major indices posting losses.  Brent oil was down -4.0% in January on the back of lower demand from emerging markets, especially due to an economic slowdown in China.  Gold stabilised (it was down -28.3% last year) and gained +3.6% for the month on the back of general risk aversion.  Risk aversion also resulted in yields on 10-year US Treasuries and German Bunds decreasing to 2.64% and 1.66%, respectively, from 3.03% and 1.93%, respectively, at the end of December.  Risk-off currencies such as the Japanese yen and the US dollar also generally appreciated against other currencies.

Emerging markets experienced another currency sell-off, triggered by Argentina’s decision to devalue its peso currency in order to protect its foreign exchange reserves, resulting in a 15% depreciation versus the US dollar within a few days.  The South African, Turkish and Indian central banks raised their key interest rates by 0.5%, 0.25%, and 5.5%, respectively, to 5.5%, 8.0%, and 10.0%, respectively.  Nevertheless, all three countries (along with several other emerging market nations) still experienced meaningful depreciation in their currencies.

For South Africa, the rand currency devalued -5.6% versus the US dollar.  Its interest rate increase was partly to stem currency outflows and partly an effort to reduce inflation, with the December production price index still increasing +6.5%.  The increase hurt consumer-oriented equities.  However, commodity producers and exporters held up or appreciated (except for the platinum sector), as the devaluation of the rand will increase their foreign revenues and profits in local currency terms.  This is despite the Association of Mineworkers and Construction Union rejecting a 9% wage offer from the platinum mining companies, ensuring continued industrial action in the sector.  The JSE All Share index was down -2.4% on the month as a result.

Further north, Egypt approved a new constitution, replacing the one crammed through parliament by the Muslim Brotherhood during the tenure of deposed President Muhammad Morsi, with 98% in favour though with only 38% turnout and a general boycott by the opposition.  Unfortunately, the referendum has only increased the polarisation of Egypt’s political landscape.  At least 49 people died in a crackdown on demonstrations marking the third anniversary of the start of the unrest that unseated former president Hosni Mubarak.  Still, Egyptian financial markets cheered the referendum result, with the EGX 30 index up +9.2% on the month.

Meanwhile, Nigerian president Goodluck Jonathan sacked a clutch of senior generals for failing to defeat violent Islamist group Boko Haram in the northern part of the country or to stop the pilfering of oil production in the south.  The Nigeria All Share index held up fairly well in light of the global sell-off, down only -1.8% on the month after rallying +47.2% last year.

In Asia, China’s Purchasing Managers Index for manufacturing declined to a six-month low, 50.5 (still greater than the 50 which signals growth) in January including a decline in export orders and manufacturing employment.  While these figures were expected due to the government’s efforts to increase previously suppressed interest rates to normal market levels (resulting in tighter credit conditions) and a rebalancing of the economy away from manufacturing towards consumption, they raise fears of a hard landing.  China’s economic growth is officially expected to slow to 7.4% this year from 7.7% in 2013, but many analysts have collected data pointing to even weaker growth.  In addition, the China Credit Trust Co. had bail out investors from one of its high yield trust products, highlighting potentially significant credit risks within the country’s $1.7 trillion trust industry.  As a result, the Shanghai Composite and Hang Seng indices had difficult starts to the year, down -3.9% and -5.5%, respectively, in January.

Neighbour Japan has inflamed tensions in the regions by reasserting its claims to disputed territory with both China and South Korea.  Many investors now fear that the Japanese government under Prime Minister Shinzo Abe is starting to gravitate towards the types of nationalist policies that collapsed Abe’s first government.  Such a scenario would jeopardise the monetary and fiscal reforms the country has made over the past year.  The Nikkei index collapsed by -8.5% in January as a result.

In Turkey, Prime Minister Recep Tayyip Erdogan removed hundreds of police officers and judiciary officials in an effort to sideline members of the opposition to prevent a wide-ranging corruption investigation into his government.  With increasing political uncertainty, a high current account deficit (-7.5% of GDP) and thin foreign exchange reserves, investors have lost confidence in the country’s lira currency, which fell -5.5% versus the US dollar over the course of the month.  Turkey’s BIST index fell -7.8% in a single week.

Further north, Russia’s central bank had to intervene to support the rouble currency.  This followed a series of setbacks for President Putin ahead of the Winter Olympics to be held in the southern resort of Sochi in February.  First, a widespread boycott of the Sochi Olympics’ opening ceremonies in protest of the government’s human rights abuses forced President Putin to make a conciliatory gesture by releasing a host of political prisoners.  This was followed by several Special Forces agents being killed or wounded in a house siege in the Dagestan region as part of the country’s crackdown on terrorists ahead of the Olympics.  Finally, Russia withheld $15bn of an $18bn bailout loan designed to aid Ukraine’s government after that country’s prime minister was forced to resign and the president had to take sick leave amid widespread protests.  These events only served to highlight Russia’s economic and political regression so far during Putin’s second term as president.  The MICEX index was down -3.3% in January.

In Europe, French President Francois Hollande announced payroll tax and public spending cuts in an effort to jumpstart the economy.  Unfortunately, this was overshadowed by disclosure of the president’s affair with an actress and the very public departure of his partner, Valerie Trierweiler.  Hollande’s job approval ratings are at all-time lows for a French president, as the country seems to be the only major European country where economic recovery does not seem to have taken hold.

In contrast, demand for mortgages in the UK rose at the fastest rate since 2007 and the unemployment rate fell sharply to 7.1%, near the 7% level that the Bank of England had previously indicated that it would start increasing interest rates.  This led to a surge in interest rate expectations, but with inflation falling to 2% annualised, the central bank was able to reassure markets that it will continue with a loose monetary policy for the time being.

The German economy grew by only 0.4% in 2013, as exports slowed due to the increasing competitiveness of other Euro-denominated countries and a decrease in demand from emerging markets due to the slowdown in that region.  Nevertheless, the economy is expected to pick up to 2% in 2014 due to the general recovery in the Eurozone.

Matteo Renzi, the leader of Italy’s centre-left government, formed an electoral pact with ousted former Prime Minister Silvio Burlesconi to reform parliamentary electoral laws designed to strengthen the power of the central government.  This could potentially strengthen the government’s hand in implementing reforms going forward.  The FTSE MIB index rose by +2.4% in January, in contrast with the UK’s FTSE 100, Germany’s DAX 30 and France’s CAC 40 indices, which followed the global sell-off with losses of -3.5%, -2.6% and -3.0%, respectively.

In the Americas, Brazil’s finance minister announced that the country had achieved a larger than expected primary fiscal surplus in 2013.  However, a significant fall in car sales highlighted a slowdown in domestic consumption and increasing economic nervousness.  The Brazilian real fell a further -3.1% versus the US dollar (after depreciating by -13.1% in 2013) and the Bovespa index fell -7.5% in January.

The US Congress concluded negotiations to a spending bill to keep the government running through to October (effectively after midterm elections later this year), though the debt ceiling still needs to be increased or suspended to prevent the government from defaulting in March.  The body also voted to extend unemployment benefits that had expired for 1.3m people in December.  Such a show of meaningful compromise in the legislature potentially bodes well for overcoming the political paralysis that has impacted financial markets over the past two years.  This was tempered by a Christmas retail sales report showing the slowest growth (2.7%) since 2009, followed by a series of poor earnings announcements from consumer and industrial companies.  The S&P 500 index was down -3.6% in January, though this comes after the index was up +29.6% in 2013.

In contrast to previous years when American and European fiscal and banking sector issues dominated investor sentiment, 2014 opened with emerging market current account deficits and political instability taking centre stage.  However, most emerging markets are in far better shape than they were heading into previous crises, with stronger fiscal balance sheets, and more developed economies and financial markets.  As a result, it is unlikely that we will see a repeat of the severity of previous crises, though these markets probably have not reached their bottoms yet and some countries will require a number of years to resolve their economic imbalances.  A more concerning situation is the increasing political tensions between China and Japan.  Not only does it distract both countries from making necessary economic reforms, but also there is a potential for military confrontation, which would likely cause a sharp global sell-off.

The current market correction has cheapened equity markets (down from expensive levels at the end of December), and as the US and Europe continue to recover, there is little to suggest the equity rally in those regions will not continue in 2014.  However, depending on the pace of the recovery, higher interest rate expectations in developed markets may start to create a headwind for markets later this year.

Sources:  RisCura, Bloomberg, US Energy Information Administration, The Economist.

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