Big thanks to Ord Minnett for the following short but sweet look at the current correction going on in Markets:
Stock markets have continued to trade down while bond prices have lifted following heightened fears of a growth slowdown in China. The correction started after China’s sudden devaluation of its currency. At the time, there was enough doubt about China’s motivation behind the move, leaving open the possibility that the adjustment in the currency was simply part of a planned liberalisation of its currency market. But the steady fall in global commodity prices and weak Chinese manufacturing updates have now moved attention and concerns to its economy.
Investors now face the same question they have had to address many times this cycle: is the fall simply a correction in a sustained medium-term bull market, or the beginning of the end of the cycle? For the moment, we are siding with a correction, but in a multi-year rally that is ageing.
Two prominent risk factors could end the economic and risk market cycle: a surge in inflation which requires the Federal Reserve to raise the cash rate more aggressively and to a higher level than currently expected; and an emerging markets debt crisis.
The latest market turmoil was not set off by the Federal Reserve but by worsening growth concerns about emerging markets, and particularly about China. Growth in emerging economies has been disappointing for years now but this time around that weakness is coming on top of a world economy that slowed to below trend in the first half of 2015.
The main threats to risk markets are now that growth stays well below trend, setting off deflationary forces, or worse, that market turmoil feeds on itself and the global economy, which in turn brings about a recession. For the moment, we believe the odds of a global recession remain low, but accept a higher risk of sustained below-trend growth.
The reason we don’t believe it is the end of the cycle is because we do not think Chinese weakness is sufficient to bring about a global recession, and because there remain sufficient supports from cheaper oil, lower bond yields and monetary easing in emerging economies. The latter does require stable currencies and, in turn, a delay by the Federal Reserve in moving on the US cash rate. A continuation of recent market turmoil and falling commodity prices would probably induce such a delay by the Federal Reserve.