A Macro View of Recent Market Volatility

US market volatilityUS market volatility

China’s recent devaluation of its currency has raised a lot of questions, and as a result we have seen a near-panic response across financial markets. However, we do not believe that the yuan’s depreciation is something that should come as an enormous shock to global markets.

While the yuan has depreciated about 5 percent over a short time, we believe the pace is likely to remain relatively controlled as the government incrementally moves toward a more market-driven environment. Importantly, we do not think the move is a signal of a massive depreciation to come.

Additionally, although the decision to depreciate the yuan resulted in a near-term increase in volatility, we do not believe it will fundamentally amplify currency depreciation across Asian or emerging market currencies over the longer term. Neighboring Asian countries, such as Japan, South Korea, Indonesia, Malaysia and Singapore, have already experienced large declines among their currencies, whereas the level of the yuan has remained relatively strong even when accounting for its recent depreciation. Therefore, we do not expect that China’s recent devaluation will likely erode the competitiveness of its neighboring countries or their exports.

When we look at how much market panic there has been, one might be under the impression China is rapidly headed into a full-blown recession. That is not our call. While we do expect moderation in China’s growth, we continue to see it as healthy and an inevitable normalization for an economy of its size. The thesis as to why we are invested in Asia remains unaltered: we expect economic growth in China to moderate, but not experience a hard-landing.

Emerging Market Fear

In light of the concerns about China, as well as potential rising interest rates in the United States, investor fears regarding emerging markets have resurfaced, although we believe that certain countries have been indiscriminately punished. A central part of our global thesis remains positioned around the strengthening economy in the United States, which is a key destination for many emerging market exports. It is our expectation that the strong labor market will provide a boost to the U.S. consumer going forward, which has been a traditional engine for global growth and support to countries that export to the United States, including Malaysia and Mexico.

Malaysia is an example where we believe investors have been overly negative. Malaysia continues to be viewed through a prism of being a commodity exporter, but it actually has a well-balanced export basket, including electronics, which would be supported by a resurfacing of the U.S. consumer. Additionally, Malaysia maintains a healthy current account surplus and holds a large cushion of international reserves with enough to cover over seven months of the country’s imports. Despite this backdrop, the Malaysian ringgit is trading near levels last seen during the Asian financial crisis of the late 1990s.

Mexico is another case of a country where the currency is trading at unprecedented levels of weakness. The Mexican peso is trading at its lowest level since the Tequila Crisis in the mid-1990s. However, we believe the country has been unfairly penalized for being a commodity exporter (namely oil) despite having less than 10 percent of its exports being oil-related. Furthermore, Mexico would be a beneficiary of an improving economic environment in the United States. Roughly four-fifths of Mexico’s exports are sent north across the border, including manufactured goods such as automobiles, which should benefit when the U.S. consumer starts to ramp up spending.

As we remain optimistic regarding the outlook for Mexico and Malaysia, it highlights how our strategies will often be contrarian. If we are not underperforming the market or our competitors for some given period, it implies we aren’t actually taking contrarian views and making those types of calls that go against prevailing market sentiment. Ultimately, we believe these periods will be short-lived as every position we hold is based on a view driven by deep conviction and fundaments.

A Matter of Time

Going forward, we anticipate significant divergences in monetary policies around the world as we would expect looser monetary policies coming from the European Central Bank, the Bank of Japan and the Reserve Bank of Australia. Conversely, we continue to expect the U.S. Federal Reserve to raise interest rates in the second half of 2015, although we are not fixated on the exact timing. In the event that we do not see a rate hike this year, we feel the market will price in the Fed being behind the curve in light of improving economic data, and the yield curve will likely steepen. We remain confident in our constructive economic outlook for the U.S. economy and believe the market will move in advance of the Fed, regardless of the dovish rhetoric, as it has historically done.

We understand that periods of volatility, like the one we have been in, are not going to be comfortable for investors. What we are seeing in the markets is almost a rewind of the “taper tantrum” we saw two years ago, when Ben Bernanke was at the helm of the Fed and hinted at a change in policy ahead. As such, we see opportunity in the current period of volatility.

Michael Hasenstab is the executive vice president and chief investment officer at Templeton Global Macro. Sonal Desai is the senior vice president and director of research at the same company.

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The Corner
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