THERE has been a tremendous pick-up in volatility in markets recently, particularly equity markets. While this will be worrying for investors, I think the current weakness will prove to be a mid-cycle correction and the US bull market still has further to run.
The catalyst for what is happening is the strengthening US dollar, which has appreciated significantly against other major currencies over the last few months. This is a result of structural improvements in the US, particularly in its fiscal and trade positions over the last few years. What has changed now is the monetary policy background. Until recently, loose monetary policy was keeping a lid on the dollar.
With the prospect of QE ending in the US, coinciding with an acceleration of action in Europe and Japan, that lid has been lifted. The dollar has started to strengthen and we could be in for a sustained and significant move higher.
When the world reserve currency appreciates, it deflates other asset classes, particularly commodities like oil, which are priced in dollar terms. This is the inverse of what happened over 2004-08, when a weaker dollar inflated commodities and helped support emerging markets. This means that financial conditions are tightening. We’ve seen the signs in credit markets, with credit spreads widening, and in equity markets, with the underperformance of mid and small cap sectors since the second quarter. More recently it’s moved to commodities, particularly oil, and we are now seeing the impact in global equity markets.
The key question investors now face is this: as financial conditions tighten, which markets will cope best?
The US will deal with it quite easily. The sustainability of the US economy, US earnings and US dividend growth is clear, and this will help sustain global equity markets in the next year or so. While it may be hard to believe now, with markets weak and the S&P 10 per cent off its high, I believe the US stock market will continue to go forward, and in 2015 it will eclipse this year’s September high of just above 2,000.
But what is good news for the US economy presents a hurdle for others, and this is particularly true of emerging markets. In the last bull market of 2003-08, emerging markets had the benefit of two key tailwinds: the rapid emergence of China; and the debasement of the US dollar and a concurrent rise in commodity prices. The export-led model that worked so successfully in the last decade has run aground.
Individual emerging markets will only succeed now if they embrace structural reforms and successfully adopt a more domestically-orientated agenda. Even countries like China, India and Mexico, which have chosen reform, could be punished as markets lose patience with the pace of change. Europe is stuck in the middle. On the one hand, real growth is hard to come by and we are seeing a widening of credit spreads in the periphery. On the other, a weaker euro will be a significant support, particularly combined with falling oil prices and weaker commodity prices. These factors could give a modest boost to activity in 2015.
On a broader level, while other markets can perform well on valuation or structural reform grounds, the US will continue to lead. The bull market of 2003-08 was about earnings growth, Chinese leadership, and emerging markets outperforming developed markets with strong commodities, thanks in part to a weaker dollar. Today’s bull market is about valuation expansion, US leadership, and sectors like pharmaceuticals, biotech and technology outperforming hard assets, against the backdrop of a firmer dollar.