Rest, Reflect, Repent: Is the flight from risk a mere moderating of recent raging expectations, or a grave portent?

SATURDAY, FEBRUARY 8, 2014

Rest, Reflect, Repent

By KOPIN TAN | MORE ARTICLES BY AUTHOR

Is the flight from risk a mere moderating of recent raging expectations, or a grave portent?

History repeats itself. Apparently, so do financial markets, because the withdrawal of the Federal Reserve’s easy-money stimulus is provoking a drama we’ve seen before.

You’d think bond prices would droop with the Fed cutting back its third — and biggest — bond-buying program, but the opposite is happening in 2014. As was the case when the first two rounds of quantitative easing ended, bonds have sprung to life, while the yield on 10-year Treasuries has shriveled from 3.03% to 2.68% in five weeks. And while the Standard & Poor’s 500 pulled back just 5.8% before buyers stepped in last week, more than half of the stocks within the index had already corrected more than 10% from their recent peaks.

Is this flight from risk a mere moderation of the giddy exuberance with which we ended 2013, or a portent of graver troubles? On one hand, most of the best-performing assets so far this year — gold, U.S. and Japanese government bonds, and volatility — were big duds last year, and would have been considered bold contrarian bets only weeks ago. Just as a hangover is the wrath of grapes (thank you, Dorothy Parker), the recent correction looks like a pause to rest, reflect, and repent after 2013’s intoxicating excesses.

On the other hand, stock-market investors, like recreational ball players, prefer their curve balls to come one at a time. Stocks could overcome the Fed’s December taper announcement to rally further, in part because the global economy was revving up at that time. Since then, however, noisy headlines about quieter factories in China, teetering currencies from Argentina to Turkey, and the wilting Nikkei have worried investors about emerging markets’ contagious blight. Domestically, the staggering drop of a U.S. manufacturing index tracking new orders — from 64.4 to 51.2 in January, the steepest since 1980 — further fanned fears about stalled growth. Suddenly, reduced Fed support seems like one cross too many to bear.

WHICH OF THESE THREATS IS WORTHY of our insomnia? Emerging markets have become a bigger driver of the planet’s economy, and one can’t be certain about the exposure that banks or other firms might have to their tumult. But Andrew Garthwaite, a Credit Suisse London-based strategist, thinks the fallout could remain manageable, assuming China doesn’t crash and burn. Export growth from developed countries to emerging markets has already slowed from 20% in late 2011 to 6.5% by last fall. Even if U.S. export growth to these markets falls to zero, the hit to nominal gross domestic product would just be 0.2%, he estimates.

Emerging-market growth also has moderated from 8.6% in early 2010 to 4.6% — a far cry from the 1990s Asian crash, when growth there was pushing decade highs. Sure, domestic excess leverage looks as stretched as it was in 1998, Garthwaite notes. But debt denominated in foreign currencies now makes up 25% of emerging-market GDP, versus 40% back then. Emerging markets also have more foreign reserves (about 30% of GDP, versus 10% then), and are running a slight surplus in aggregate current account balances, versus a 2% deficit two decades ago. “Only Turkey has the toxic combination of a large current account deficit and high net external debt,” he writes.

Stalling U.S. growth would be a grimmer prospect. But growth hasn’t yet stalled — it has just slowed relative to our recently raging expectations. More important, we won’t know the true extent of any deterioration until we thaw from winter’s glacial grip. Real men don’t go on about the weather. But when parts of the U.S. become as cold as the North Pole, and even the real housewives of Atlanta are stuffing their much-brandished cleavage into winter wear, then it isn’t far-fetched to expect buying, building, or hiring to hibernate a wee bit.

Friday’s jobs report stank: just 113,000 jobs added last month, after 75,000 in December. Yet, January also saw more construction jobs added than in any month since 2006, despite the cold. Also, “hours worked were flat, which would suggest that the economy made up for a weather impact,” notes Strategas’ chief economist, Don Rissmiller. Other data like jobless claims and bank lending corroborate the notion that the economic picture hasn’t changed dramatically.

WHAT HAS CHANGED, though, is our embrace of the stock rally. Investors pulled $18.8 billion from stock mutual funds and exchange-traded funds, which Lipper says is the biggest weekly yanking on record, while they plowed $10.7 billion into bond funds. The Dow Jones Industrials Average dipped below its 200-day average, and the crop of S&P 500 stocks holding above their 50-day averages has plummeted in a month from 75% to 35%, the lowest since mid-2009. The herd of bullish bloggers quickly shrank to the lowest level since June, and social-media darlings from Twitter (ticker: TWTR) toLinkedIn (LNKD) are correcting.

Already, speculation has increased that the Fed must call off its tapering of quantitative easing. We expect history to repeat itself, and the Fed to revert to maximum accommodation — never mind what tapering has to do with this pause, or how the Fed isn’t obliged to hold up foreign markets. “Tapering, the usual suspect, has been falsely accused here,” says David Kelly, JPMorgan Funds’ chief global strategist. “The proof of its innocence is in how Treasury yields are down, not up, since tapering began.” Kelly thinks economic growth is still resilient enough, and monetary policy still supportive enough, to keep favoring U.S. and global stocks over bonds.