Macro: The Bottom Line (4/28/2014)

Four months, four bogeymen

 

As we round out April, it's an opportune moment to look back at the markets in 2014 so far. And what a year it's been. By all accounts, what we've been through year-to-date equates to nothing less than four months of indecision. It seems like the markets have been picking petty fights all along, with individual sectors going from investor darling one month to bogeyman the next. Here's a quick summary of what's been going on:

Start of 2014: All is fine. Economic data (notwithstanding the brutal winter in the Northeast and Midwest) remains supportive of an upbeat US growth story. 10Y US Treasury yields are at 3%, a level it hasn't seen since 2011.

Late January - Bogeyman #1: EM

All started with Argentina's decision to devalue its peso currency by the most in over a decade. Suddenly, everyone seemed to be talking about the emerging economies' external imbalances, and a new term - "fragile five" - came to replace BRICS as the most in-vogue acronym among EM investors. Investor darlings of the last five years - Brazil, Turkey, Indonesia - remained the focus of attention, but now for precisely the wrong reasons.

February to March - Bogeyman #2: China

China has long distinguished itself from its EM peers in one major way: it runs both a current account and capital account surplus. In other words, there are more funds flowing into the country - whether in the form of export revenue or capital/investment flows - than there are leaving in the other direction. A key beneficiary of this phenomenon has been China's yuan currency, which was increasingly being treated as a sure bet to make money. That all changed when the Chinese central bank (PBOC) decided to shake things up a little, engineering a steep 3% depreciation in the RMB. Throw in some disappointing data - especially PMIs and industrial production - and all of a sudden, the rock-solid China story was no longer what it used to be. The country was no longer the world's growth engine; rather, it was now the home to the world's most bloated shadow banking system on the precipice of collapse.

Late March - Bogeyman #3: Janet Yellen

As we described in our last post on April 14th, new Fed Chair Yellen unleashed an unnecessary bout of volatility in the US rate markets on March 19th by providing a numerical timeframe for a rate hike - a huge no-no for the most powerful central banker in the world. But even worse was the FOMC's attempts to backpedal once they realized the scale of their misstep. In doing so, they essentially threw the credibility of Ben Bernanke's most notable innovation (member-specific quarterly forecasts for rates and inflation) into serious question.

April - Bogeyman #4: Tech stocks

Yep, you've all read about it. April was an ugly month for the Nasdaq, which fell 3 percent. After lurking in the shadows for years, the dreaded "V-word" (valuations) suddenly reared its ugly head. And with earnings season getting off to a start, don't expect the close scrutiny of valuations to go away anytime soon.

So how does one make sense of all this? Which of the four bogeymen ought we to be most afraid of?

 

Unfortunately, these questions don't lead themselves to easy answers. But what we can say is: there's a common thread in all four. If there's been one factor underpinning each of the scenarios discussed above - whether it's boundless euphoria over China and other EMs, or multi-year rallies from US bonds to tech stocks - it's been the perception that Fed money printing would continue ad infinitum. What about the mounting fundamental imbalances underlying these securities (stretched valuations, reckless credit growth in China, current account deficits)? "Not a problem," so the thinking went, "as long the Fed is there as a backstop, there will always be buyers." But now that the FOMC has begun reducing its monthly splurging program (i.e. scaling back QE), fundamentals suddenly can't be shoved under the rug so easily with a Fed-as-buyer-of-last-resort argument. The bottom line: let the four bogeymen of the last four months be a reminder to you that fundamentals matter, and they will matter even more in the coming months. All good comes to those who can differentiate between the good, the bad, and the ugly.