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(Reuters) – A full-scale flight from emerging market assets accelerated on Friday, setting global shares on course for their worst week this year and driving investors to safe-haven assets including U.S. Treasuries, the yen and gold.
U.S. stocks slumped, putting the benchmark S&P 500 on track for its worst drop since November 7 and pushing the index down 1.8 percent for the week. Concerns about slower growth in China, reduced support from U.S. monetary policy and political problems in Turkey, Argentina and Ukraine drove the selling.
The Turkish lira hit a record low. Argentina’s peso fell again after the country’s central bank abandoned its support of the currency.
The declines mirror moves from last June when developing country stocks fell almost 18 percent over about two months and hit global shares.
The broad nature of the selloff combines country-specific problems with the reality that reduced U.S. Federal Reserve bond buying reduces the liquidity that has in the past boosted higher-yielding emerging markets assets.
The Fed last month pared its monthly purchases of bonds by $10 billion to $75 billion. The U.S. central bank will hold a policy meeting on Tuesday and Wednesday and is widely expected to again pare its stimulus program.
“We expect the emerging market selloff to get worse before it starts getting better,” said Lorne Baring, managing director of B Capital Wealth Management in Geneva. “There’s definitely contagion spreading and it’s crossing over from emerging to developed in terms of sentiment.”
Activity was heavy in exchange-traded funds focused on emerging markets. The iShares Morgan Stanley EM ETF was the second-most active issue in New York trading, trailing only the S&P 500’s tracking ETF.
An MSCI index of emerging market shares fell as much as 1.6 percent. Since mid-October, the index has lost more than 9 percent. The MSCI all-country world equity index was down 1.6 percent.
Funds have continued to flee emerging market equities. In the week ended January 22, data from Thomson Reuters Lipper service showed outflows from U.S.-domiciled emerging market equity funds of $422.41 million, the sixth week of outflows out of the last seven.
Emerging market debt funds saw a 32nd week of outflows out of the last 35, with $200 million in net redemptions from the 250 funds tracked by Lipper.
“It’s just the final realization that they can’t continue to grow as an economy the same way they did before,” said Andres Garcia-Amaya, global market strategist at J.P. Morgan Funds in New York. “It’s a combination of less liquidity for these countries that depended on foreign money and China kind of throwing some curve balls as well.”
The Turkish lira hit a record low of 2.33 to the dollar, even after the central bank spent at least $2 billion trying to prop it up on Thursday.
Turkey’s new dollar bond, first sold on Wednesday, fell below its launch price. The cost of insuring against a Turkish default rose to an 18-month high and Ukraine’s debt insurance costs hit their highest level since Kiev agreed a rescue deal with Russia in December.
Argentina decided to loosen strict foreign exchange controls a day after the peso suffered its steepest daily decline since the country’s 2002 financial crisis [ID:nL2N0KY0FC]. On Friday, it was down 2.8 percent.
On Wall Street shares sank.
The Dow Jones industrial average was down 205.12 points, or 1.27 percent, at 15,992.23. The Standard & Poor’s 500 Index was down 24.93 points, or 1.36 percent, at 1,803.53. The Nasdaq Composite Index was down 66.82 points, or 1.58 percent, at 4,152.05.
But in a signal that the selling may be overextended, investors were willing to pay more for protection against a drop in the S&P 500 on Friday than for three months down the road. The last time the spread between the CBOE volatility index and three-month VIX futuresturned negative was in mid- October, shortly after a 4.8 percent pullback in the S&P 500 opened the door to the last leg of the 2013 market rally.
European shares suffered their biggest fall in seven months. The FTSEurofirst 300 index of top European shares closed down 2.4 percent at 1,301.34 points. The index has now erased all its gains for 2014, and is down 1.1 percent on the year.
Spain’s IBEX index, highly exposed to Latin America, was the worst-hit in Europe, falling 3.69 percent.
The dollar index was flat, a day after falling 0.9 percent against a basket of majorcurrencies, including the euro, yen, Swiss franc and sterling. That was its worst one-day performance in three months.
A flight to safety lifted currencies backed by a current account surplus, such as the Japanese yen and Swiss franc, and highly rated government bonds. German Bund futures rose and 10-year U.S. Treasury yields hit an eight-week low below 2.75 percent.
Gold traded close to its highest level in nine weeks and was poised for a fifth straight weekly climb as weaker equities burnished its safe-haven appeal. Spot gold rose to $1265.10, up from $1263.95.
(Reporting by Barani Krishnan; Additional reporting by Dan Bases and Toni Vorobyova; Editing by Nigel Stephenson, Nick Zieminski and Leslie Adler)
China’s push to open up its economy is winning praise from Goldman Sachs Group Inc. to Morgan Stanley and Jefferies Group LLC, which predicted last month a “massive” multiyear bull run for stocks.
John-Paul Smith doesn’t share the enthusiasm.
When the Deutsche Bank AG equity strategist looks at the country, he says he detects some of the same signs of a financial meltdown that led him to predictRussia’s 1998 stock market crash months in advance. China’s expansion is being fueled by soaring corporate borrowing, a high-risk model that needs to be replaced by the kind of free-market measures and budget cuts that fed Russia’s growth in the aftermath of the country’s default and subsequent 44 percent monthly tumble in the Micex Index (INDEXCF), Smith said.
“There is potential for a debt trap in industrial companies which can trigger an economy-wide financial crisis as early as next year,” Smith said in an interview from London on Dec. 12, a day after he issued a report predicting China’s slowdown will lead to a 10 percent decline in emerging-market stocks next year. “If I am wrong on China, I am wrong on everything.”
Smith’s 2013 call for a drop of at least 10 percent in developing-country stocks has proven prescient. The MSCI Emerging-Markets Index has slid 5.9 percent, trailing the 22 percent rally in MSCI’s developed-markets measure. The Shanghai Composite Index, the benchmark equity gauge in the world’s second-biggest economy, has lost 7.9 percent, heading for its third annual decline in four years. The measure rose 0.2 percent at today’s close after falling for nine days.
The selloff in Chinese (SHCOMP) stocks has eased since mid-November, when the government’s top policy makers pledged the biggest expansion of economic freedoms in at least two decades. Measures included encouraging private investment in state-controlled industries, accelerating convertibility of the currency and liberalizing interest rates, an initiative that helped drive interbank borrowing costs to a six-month high last week.
China’s benchmark money-market rate climbed for a seventh day today, with the seven-day repurchase rate, a gauge of funding availability in the banking system, jumping 124 basis points to 8.84 percent, the highest level since June 20.
Morgan Stanley said the free-market push will boost consumption, technology and health-care stocks while Jefferies Group said companies in industries including auto and insurance will do the best amid the bull market rally. Goldman Sachs upgraded Chinese equities to overweight in part because of the country’s “commitment to reform, which seems quite palpable.”
Smith, who has been bearish on China since he joined Deutsche Bank in 2010 from Pictet Asset Management, said he wants to see how the government carries out the policy changes.
The economy is at risk of expanding less than 5 percent annually over the next few years, he said. Gross domestic product has grown less than 8 percent in each of the past six quarters, down from a high of 14 percent in 2007.
“The proof will be in the implementation,” said Smith, who’s the global emerging markets equities strategist at the Frankfurt-based bank. “It will be very interesting to see if they really intend to go down the same ‘hard state liberal economic’ path that Russia did from 1999 to the autumn of 2003. So far, there is no indication they are prepared” for that.
Smith, 52, has honed his market acumen over a three-decade career. Raised in the English town of Glossop, near Manchester, he studied modern history at Oxford’s Merton College before going to work as a European fund manager with Royal Insurance in 1983. From there, he did stints at TSB Investment Management, Rothschild Asset Management and Moscow-based Brunswick Brokerage, before joining Morgan Stanley in 1995 as a Russian equity strategist.
It was at Morgan Stanley that Smith made the call that he’s still best known for today, a forecast that got its inspiration in part from a visit he made in 1997 to a port city 600 miles (965 kilometers) south of Moscow.
In Rostov-on-Don, he got an up-close look at a combine-harvester maker that surprised him: the company was taking a year to build its planned weekly quota, it was still employing two-thirds of its Soviet-era workforce and it was drowning in unpaid bills and barter deals.
That trip helped Smith understand the growing financial crisis that would lead Russia to devalue the ruble and default on $40 billion of domestic debt in August 1998.
In a June 1997 report, he wrote that investors may not have begun to “really focus on the possible fallout” from companies’ growing financial struggles. Smith highlighted the Rostov-on-Don trip in a January 1998 note in which he reiterated that investors were too optimistic. Two months later, he wrote that Russia had to “sort the situation out” that year or its financing burden would become unsustainable and trigger a devaluation.
In the aftermath of the collapse, Smith turned bullish on Russian stocks at an investors’ meeting in New York in 1999. The market soared 235 percent that year. He calls it the best forecast of his career.
“I suggested that Russia was now cheap and should be an overweight and the meeting ended very quickly indeed amid some expressions of minor outrage,” said Smith, who is underweight Russian stocks today.
Following those calls, Smith spent nine years at Pictet, first as head of emerging markets equities where funds managed by his team almost quadrupled to $9 billion between 2001 and 2005. His Eastern European Trust Fund, with 40 percent of its assets in Russian equities on average, outperformed the MSCI Emerging Market Eastern Europe dollar index by 1.5 percentage points at the end of 2005.
“When he joined Pictet in 2001, it was like the second coming as the savior of our emerging markets business,” Stephen Barber, a managing director at parent company Pictet & Cie, wrote in a farewell note about Smith in June 2010. “He did seem to perform miracles in the years that followed, as our emerging markets business recovered strongly.”
While Barber said that Smith had an ability to avoid getting caught up in the market euphoria, he often made his calls too early.
“When he was with us, he was for a long period bearish on China,” Barber said. “The analysis was absolutely correct but in the meantime, you can miss out on a bull market.”
“When you have a great strategist who has these insights, you have to nurture these insights, not kill them,” he said.
Smith wrote an article for the Financial Times in December 2007 saying he sensed that the worst in the subprime mortgage crisis was over and that the U.S. market was poised to rally. The worst financial crisis since the Great Depression followed.
The analyst, who has also been wrongly bearish on oil since April 2011, says he learned to never take a strong view without obtaining detailed understanding of the underlying fundamentals, such as what types of instruments were being held in the financial industry.
Smith’s China call is another strong view. His colleagues at other banks are underestimating the risks, he said.
China’s total credit, including items off bank balance sheets, climbed to about 190 percent of the economy by the end of 2012 from 124 percent in 2008, according to Fitch Ratings Ltd. That was faster lending growth than in Japan during the late 1980s that foreshadowed two decades of deflation, and in the U.S. before the financial crisis of 2008.
“It is really at the corporate level and at the micro level in China that the fate of the financial market and the economy there is going to be determined,” Smith said. “China is not such a safe haven as most market commentators appear to believe.”