There are clearly three main drivers in today’s markets, which explain the recent volatility and lack of direction. The three factors are: the slowdown in China and fears of a hard landing; the US business cycle; and, crisis flares from the Eurozone periphery. To some extent these show the market is addicted to extravagant Chinese growth, and increasing monetary easing in the US and Europe.

Markets perceive that Chinese growth around 10% is a necessary condition for the global economy to grow, without qualification. China has gone and continues to go through a historic transformation, and it should be expected to converge to more ‘normal’ growth rates. Many other countries have opened up their economies and embarked on long high growth paths, to some extent fed by a significant supply of inexpensive resources that join the international economy and adopt modern technologies (labor, in the case of China). China’s experience is unique in its size and how steady it has been over the last decades, thus its unprecedented impact in the global economy. But it is convergence after all, which means that gradually the capital/labor ratio grows closer to that of the rest of the world (as investment adds capital to the labor supply moving from the mainland to the coast), per capita GDP and labor costs converge to those of other countries that had developed before (at different paces and times). Thus, it should be expected for growth to moderate, which would mean that at some point the upper bound of its growth range would be 7% and not 12% (7% is maybe the best estimate of the current pace, and most forecasts for the year are around 8%). This is not bad or worrisome. We need to remember that under the average growth rate that China showed over the last 10 years an economy doubles its size in 7.5 years (in real local terms), and in the case of China that had real appreciation, its economy doubled in size in USD terms every 4.5 years. Thus, 5% growth today could be the same for the world economy as 10% growth 5-7 years ago (assuming the world economy did not grow). In other words, Chinese growth should be expected to converge to a more ‘normal’ range, maybe it is now, and if it does it should not cause a disaster per se.

Our previous blog was about the Fed hinting that it would not continue expanding its balance sheet and the impact on markets. Though that first hint did not have an immediate impact, subsequent ones did, showing expectations of global growth (or the US business cycle) are not yet strong enough to accept a withdrawal of the morphine that has helped markets over the last 3 years. The market has become addicted to policy stimulus, which means it does not trust the underlying strength of economies to be sustainable. This is clearly the key driver for US equity markets. The health and pace of the US business cycle has proven to be the key driver, as shown in a recent research piece by Goldman Sachs (regression analysis of factors influencing markets). And the recent reactions to different data releases confirm the statistical work. Despite the fact that corporate earnings continue to show that firms are basically healthy and growing (albeit at a lower pace than in the previous two years, and with better results not always as a consequence of higher revenues), watching for clearer signs about the strength of the business cycle in the US is essential for positioning for the rest of the year. (note this was written before the FOMC meeting, statements and press conference of April 25^th)

The euro crisis is like a monster in a horror movie, it keeps coming back. There are two ways of looking at it. The optimistic way focuses on the ECB having eliminated the risks around bank refinancing, which frames the risks as those of medium-term fiscal sustainability as opposed to short-term liquidity. The pessimistic look focuses on the fact that after every crisis episode markets seem to recover around worse levels with respect to the government’s costs of funding. After each mini crisis that we believe we overcome, the governments that are under pressure end up having a somewhat more difficult financing situation as before that mini crisis. We think the ECB has done a lot to minimize the short-term financing risks, and that governments are working towards medium-term sustainability. However, the latter is an endogenous and dynamic concept, where market expectations play a crucial role. If markets (which includes those who invest and hire or fire people in those economies) believe that a particular economy is unsustainable, that view would most likely materialize. We think Europe will continue to provide shocks and episodes for a long time, as monetary expansion can only buy time, and only structural reforms, fiscal consolidation and growth can eliminate risks.

Even though this northern hemisphere summer seems to be starting not that different from the one last year, we believe it should not be as damaging to markets. However, the three drivers above are real, and their evolution is still uncertain. We are somewhat optimistic about the continuation of a mild recovery in the US economy. We believe that convergence in China is not bad, but we are also aware that markets expect a reacceleration engineered by policy easing, which means there is room for disappointment. On the euro, the elections in France (second round in almost 2 weeks) are maybe more important than watching every bond auction in Spain and Italy, and believe that it will remain a concern for markets for many many more months. Exposed but defensive continues to be the theme, with focus on the details of the allocation, as differentiation across regions/countries and segments has increased.