August, traditionally a quiet and low liquidity month has seen an indiscriminate sell-off on global markets intensify over the past few days, with investors displaying panic behaviour. The rand plunged by R1/US dollar on Monday morning to briefly touch R14/US dollar.

This last happened in October 2008 following the Lehmann Brothers collapse. Then, the US was at the epicentre of the financial crisis; now fears are that China’s growth slowdown is worse than expected and authorities are not able to stabilise financial markets and stem the rout on the mainland stock-exchanges (though the Shanghai Composite is still positive year-on-year). These doubts intensified after the surprise (but relatively small) yuan devaluation two weeks ago.

China slowing, but still growing China’s economic growth rates have been slowing since 2011, but the market now appears fearful of a “hard landing”, i.e. full blown recession.
These fears look overblown. Last week, the International Monetary Fund said it expects growth of 6.8% in 2015 and 6.3% in 2016. This slower
growth is “better” growth since it is more sustainable and balanced.
The US economy is still growing around 2% per year and has made significant progress in lowering unemployment. Indeed, one of the factors
adding to market volatility is the anticipation of interest rate increases in the US, but interest rate increases are a sign of the economy doing better,
not worse. The Eurozone economy is also improving after lagging for years. Thus the US, Eurozone and China – the world’s largest economies
accounting for half of global gross domestic product – are growing. This does not look like 2008 when the global economy virtually came to a standstill overnight as financial markets and the banking system froze over.

Emerging Markets under pressure

But are we perhaps not heading for a 1998 style Emerging Markets crisis? Emerging economies have come under pressure as commodity prices have fallen and Chinese growth slowed. A strengthening US dollar in anticipation of rising rates has also hurt those countries with large current account deficits. However we believe Emerging Markets
are much less vulnerable than in 1998 precisely because the lessons of that crisis have been taken on board: foreign exchange reserves have been bolstered and currencies now trade freely and act as shock absorbers.

For instance, the SA Reserve Bank hiked the prime rate almost overnight to 25% in 1998 to protect the rand as the country ran out of foreign exchange reserves.

Emerging market assets have underperformed developed markets since 2011. Emerging market equities are trading at a 30% discount to developed markets, the largest since late 2005, based on 12-month forward price: earnings ratios. These equities are already priced for disappointment.

Similarly on the exchange rate front, most Emerging Market currencies are now very cheap on a real trade-weighted basis. As an example, South Africa’s real effective exchange rate fell from being slightly above its long-term value in 2010 to currently more than one standard deviation below its long-term value. That doesn’t mean it cannot depreciate further, but it has already fallen a lot and if circumstances improve, the currency can surprise on the upside from such bombed out levels.

Investors have already drastically cut exposure to Emerging Markets. According to a Financial Times report, capital outflows from Emerging Markets have totalled $1trillion over the past 13 months, double the outflows during the global financial crisis. The time to be most worried about an asset class is when it trades at a premium and investors have
piled into it.

What should investors do?
Do not fight panic with panic. Investors need to remember that market volatility is normal, even though the events of the past few days have been extreme. Focus on your goals and the investment horizon attached to them. The time to change tack is when your personal circumstances have changed, not in response to market conditions. Drawing up a financial plan helps guide you through turbulent times; do not abandon your plan when markets are wobbling.
What are we doing?
The Investment Strategies are well diversified across asset classes, regions and fund managers. Asset allocation is done inside the fund with the
eye on the long-term return targets of each strategy. For instance, the strategies have long been underweight local equities and overweight global assets, providing maximum protection against a weaker rand. Market conditions, valuations and the economic outlook are continuously taken into account by the fund managers so financial planners and clients
can focus on what matters most to them.

Courtesy of Old Mutual