Macro Matters: Five reasons the market oversold


Joachim Fels

In last week’s “Macro Matters,” I argued that China’s currency regime change is bad news for the global economy and risk assets unless it will be accompanied by further domestic monetary easing and reforms in China and unless central banks elsewhere smell the coffee and ease policy further or postpone tightening.

My point was that in the absence of such actions, which could result in a win-win for the global economy and risk assets, China’s currency move would likely be seen as beggar-thy-neighbor policy and thus azero-sum game for the global economy.

Alas, with China’s central bank (the PBOC) refraining from easing policy last week, and with other major central bankers on vacation, investors decided to endorse an even more negative interpretation: not win-win, nor even zero-sum, but rather negative-sum as both Chinese and global risk assets sold off in tandem.
In times of volatility, I am reminded of how famous investor Benjamin Graham described “Mr. Market” as a manic depressive who fluctuates between euphoria and despair. As I see it, there are five reasons why Mr. Market should remain calm.

1. Everyone and their dog has known for some time that most emerging market (EM) economies are in the midst of a very bumpy, long transition to new growth models. The mood on EM among investors has been bearish for a long time, and rightly so. How much worse can it really get after last week?

2. As regards negative spillovers from emerging to developed economies, yes, they exist, but initial economic and financial conditions in the latter are the strongest they’ve been in many years. Domestic demand in the U.S. and U.K. looks solid, and even the euro area is enjoying a slow but broad-based economic recovery.

3. True, plummeting commodity prices put commodity-producing economies and sectors under pressure and increase vulnerabilities and default risks. However, the world as a whole, and consumers and businesses that use rather than produce commodities in particular, are still better off as we have to pay less for the useful things we drill and dig out of the ground and employ as an important production factor.

4. Given Mr. Market’s precarious condition, central banks stand by to offer some medication. China already eased banks’ reserve requirements and cut interest rates today. Mario Draghi may use the 3 September press conference to emphasize that the European Central Bank stands ready to do more if needed. And in Japan, the chances of an extension and/or top-up of the current monetary easing program as early as October have increased with the contraction of GDP in Q2 and inflation hovering way below target.

5. Finally, as regards the Federal Reserve, FOMC participants may be asking themselves whether they can remain “reasonably confident” that inflation will return to the 2% objective over time given the drop in market-based inflation expectations, the strength of the U.S. dollar and the chaos in risk assets. Prudent timing of the first rate hike will be crucial to calm markets.

In short, provided central banks act appropriately, Mr. Market may well recover soon.

By Joachim Fels, PIMCO

You must be logged in to post or view comments.