The downward volatility we’ve seen in the last year or so in emerging market equity and debt, precious metals, industrial commodities and finally us equities and bond yields has typically been blamed on weak demand from emerging markets and the new-found strength of the U.S. dollar.
And recently there’s been talk that the growth issues in emerging markets is merely the “third wave” of what has been a rolling financial crisis that started here and nearly brought the global economy to its knees in 2008/09, moved its way to Europe in 2010/11 (the jury is still out on whether or not it has actually ended there) and has in the last 18 months engulfed countries like Brazil, Russia and most importantly China.
Yesterday, Business Insider had a piece (Investors are terrified by the ‘Third Wave’ of the financial crisis) arguing that for the rolling crisis to truly end, there needs to be massive deleveraging everywhere, as has been done in the U.S. and is underway in Europe and likely to come to a head in China soon:
A Chinese slowdown has knock-on effects for other emerging markets given just how much raw material China has hoovered up over the years. Its voracious appetite has helped support plenty of economies.
Meanwhile, the private sector in many emerging markets has been bingeing on credit for the last decade, while corporations in the western world have been slowing down their debt accumulation, or even deleveraging.
That’s led to what HSBC has called a “toxic mix” of debt and low growth in emerging markets.Goldman Sachs’ recently dubbed the cocktail the “third wave” of the financial crisis, driven by China’s shifting economy.
While the S&P 500 (SPX) levitates within a few percent from its all time highs (made this Summer), it’s important to note that Brazilian, Chinese and Russian equity markets are once again showing signs of stress, with Brazil’s Bovespa down nearly 8% from its one month high, China’s Shanghai Composite down 6% from its one month high and Russian’s RTS index down 7% in the last week. This is with the backdrop of a surging US Dollar. The USD Index (DXY) is about to trade at levels not seen since 2003 (a time when the Fed Funds rate was around 1%, which prior to 2009 was the lowest rate ever!)
As I write, I am listening in the background to peeps on CNBC talking about a Santa Claus Rally. The discussions around the term almost make me vomit because the implication is it’s driven by happy investors around the Holidays. In reality, when stocks rally into year end it is nothing more than asset managers marking their books so they can get paid! And as we’ve seen the past two years, the Santa Rally can quickly become a New Year’s Hangover.
At this point with the SPX up 1% on the year I think its safe to say that the most likely outcome is up or down a couple percent from current levels into year end. The Dec 31st at the money straddle is offered at about 3.25% of the index, probably a bit rich, but reflecting nervousness in front of central bank meetings. This will come in dramatically right after the Dec 16th FOMC meeting. But if things were to heat up in the coming weeks in emerging market equity and credit markets, with the inverse reaction in global commodity markets, no matter what happens into year end, the SPX could be setting up for the sort of 5% or so decline its has experienced in the last two January into early February.