Equity markets already sagging prior to yuan devaluation jolt

London

EVEN before Tuesday's sharp yuan devaluation, global equity markets were already beginning to sag as valuations were regarded as pricey and institutions were getting cautious.

From Wall Street to London, Frankfurt, Tokyo and Singapore, stock market indices were down from their heady peaks, while China, Hong Kong, Russia and Brazil have been struggling to lift themselves from depression. To be sure, global equity markets were looking for an excuse to correct after the weak rallies following Greece negotiating a bailout deal and, the US and Iran agreeing on the controversial deal, market strategists say.

A fund manager survey of BOA Merrill Lynch between Aug 1 and Aug 7, showed that "investors have shifted robustly into liquidity with a net 27 per cent of respondents to the global survey overweight cash in August, up from a net 12 per cent in July".

"Cash readings are at their highest since June 2012," opines BOA Merrill Lynch Research. "The proportion of asset allocators overweight equities has tumbled by 17 percentage points in one month, to a net 44 per cent in August. The number of survey respondents hedging against a sharp fall in equity markets in the coming three months has reached its highest level since October 2008."

"The market melt-up is over, or at least on pause, as investors seek refuge while they digest world events and the prospect of higher rates," said Michael Hartnett, chief investment strategist at BOA Merrill Lynch Research.

"We see further de-risking to come in Europe," added Manish Kabra, European equity and quantitative strategist.

A net 13 per cent of asset allocators are overweight eurozone equities - a fall of 22 percentage points in one month. US equities also lost ground but only a four percentage point drop to a net 6 per cent. Furthermore, a net 30 per cent of global investors believe that the 12-month profit outlook is worse in Europe than in any other region.

In contrast a net 30 per cent of asset allocators are now overweight Japanese equities, a rise from a net 26 per cent in July.

Equity markets were thus already jittery prior to the sudden devaluation announcement of China. It gave markets a further downward jolt and raised fears that US, German, British and other exports to China would decline. Oil and other commodity prices plunged in tandem with resource stocks on worries that yuan devaluation would raise the cost of raw material imports.

The fear now is that there will be growing speculative pressure on further yuan devaluation following a further decline of the currency on Wednesday. The Bank of China and the government may be concerned that sales of the yuan will get out of hand, currency analysts say. To stabilise the yuan and reduce upward pressure of the US dollar, China may sell US Treasury bonds.

The worry is that China's sales will cause US Treasury bond prices to fall and yields would then rise, with a knock on effect on corporate bonds equities and other financial assets.

In previous downturns since the crash of 2008 and early 2009, investors tended to bottom pick and their purchases were successful. The big question is whether markets could fall further than expected.

Norbert Keimling, head of Capital Market Research at Star Capital, believes that cyclically adjusted price earnings (CAPE) ratios should be researched to assess which markets are under or overvalued. Robert J Shiller, winner of the Nobel Prize for Economics, developed CAPE which denotes the ratio of the current market price to the average inflation-adjusted profits of the 10 preceding years.

The CAPE measures whether the valuation of an equity market is high or low compared with its profit level. When CAPE is low, returns are higher over the long run and when it is high, returns are much lower or poor. The table shows that the cheapest markets in terms of Cape are Russia, Brazil, Italy and Spain while the US, Japan, Germany, China and India are the most expensive while Singapore and the UK are reasonable value.