Markets regained their composure and in some cases tested the highs for the year in February, the notable laggards being the emerging markets and Japan.
In Japan’s case, we await the fundamental confirmation that prime minister Shinzo Abe’s policies are having lasting, positive, constructive impacts on the economy and upon businesses. The rapid depreciation of the yen and the shutting down of the nuclear power stations following the 2011 Fukushima nuclear disaster has resulted in energy prices spiking, resulting in ‘bad’ cost-driven inflation.
Demand-driven inflation is the ‘Holy Grail’ that Japan is aiming to create. Should it appear, it will likely be the result of increased economic activity, but evidence of this is yet to come through. We continue to watch for real wage growth which could lead to a broader, consumer-led recovery and further signs that the dramatic measures Japan has instigated are bearing fruit.
The emerging markets are not a homogenous group, each country having different dynamics, but as is often the case when troubles hit, correlations spike. In general, these countries have been hit by a cyclical slowdown during high inflation, which has been compounded by the US Federal Reserve’s decision to taper its monthly purchases of bonds.
Recent actions by the Fed have had the result of draining liquidity from the global financial system, which is akin to withdrawing oxygen from a flame. As soon as liquidity begins to reduce, it is those markets which have attracted short-term speculative investors that are most vulnerable. At the first signs of trouble, this capital, sometimes termed ‘tourist money’, takes flight, which has a significant negative impact on asset prices and currencies to boot. It is these movements that the emerging markets are dealing with now.
The duration of these flows is a guess, but bargain prices will emerge from the assets cast aside by investors late to join the bandwagon. However, in our opinion this drama is likely to have a number of further scenes to play out.
Political unrest and social upheaval remains a cog that continues to turn in these areas, Ukraine being the most recent flash point, where bloodshed has led to the deposing of the previous leaders. The tussle between Europe and Russia over this strategically critical region will be exceptionally difficult given the concentration of gas and oil pipelines that course through the country, linking Russia’s energy resources to western Europe. Anything that clogs these arteries will have knock-on impacts well beyond Ukrainian borders.
Looking ahead, we believe that the withdrawal of liquidity by the Fed may change the current status quo. The emerging markets are already feeling the impact of investors retrenching to their home markets, but it would be foolish to think that the developed world can continue unaffected.
Should the Fed decide to increase the rate of its tapering, or in the circumstance where macroeconomic data begins to point towards interest rate rises before the markets currently expect them, then equity markets are likely to falter.