Emerging markets equities - Macro or fundamental factors as drivers?

Are emerging markets equity returns driven by economic growth? On a simple level, there should be a link between growth and equity returns for a country, yet nothing is simple. The behavior and valuation of firms is not  tied to economic growth as described in the paper, "What matters more for emerging markets investors: Economic growth or EPS growth?" The figure show that for both developed and emerging markets, real stock returns are not correlated with GDP growth. The drivers of stock returns will be tied to the fundamentals of firms within the country index.

The long-term relationship between fundamentals like EPS and DPS are positively correlated while the correlations with per capita GDP are not significant. The long-term fundamentals are the main driver for country equity returns.

However, country stock returns may not be immune to changes in the business cycle and short-term growth. It is important to link macro dynamics to firm fundamentals which will drive conditional returns in the short-run.

The housing cycle is the business cycle - Can housing tell us something about the real economy and policy

 

Housing markets are sensitive to interest rates. Housing markets also are sensitive to rising disposable real income and the business cycle. Housing markets given the slow changes in supply can be subject to bubbles. A slowdown in economic activity or a change in consumer optimism makes housing a good indicator of economic health.

The GFC may have been caused by the reversal in the housing market, but other business cycles have seen housing turndown precede or be coincident to a general downturn. 

Housing can be a canary in the coal mine with respect to recessions. The Fed sees these numbers but feels the housing markets can be sacrificed for the good of bringing down inflation through higher rates. 

Housing supply has spiked as seen in other recessions. We are seeing traffic of buyers slow. Housing is selling at a decreasing rate and the number of homes for sale is increasing. Housing prices YoY are still positive, but price measures like the Case-Shiller index have a lag structure that is not giving us a good idea of current conditions. More recent survey data are showing growing weakness. 

There is a housing bubble across the US, and it is much worse than anything seen in 2007-2008. The leverage may not be the same, but the price increases are significantly higher in many cities. The peak may have been reached and now we will see how much prices will fall. This will have a negative wealth effect on consumer which will be enhanced with the negative wealth effect from holding stocks and bonds. The canary is singing but the tune is not anything investors would like to hear.

Global equity correlation - Driven by common factors

International equity markets seem to be increasing synchronized, that is, the return correlations across global markets have increased and diversification has gone down. Researchers have suggested two lines of thinking that drive this increase: one, a common factor or set of macro factors that move together, and two,  the economic or financial linkage between countries, spatial relationships.

Researchers have found that accounting for both factors will improve our understanding of global equity correlation. The common factor has been explored by several researchers who have suggested that there is a common risk factor associated with increased global volatility and a common financial factors which is associated with US monetary policy. An increase in risk will change risk appetites and lead to lower returns across all equity markets. An increase in US interest rates which tightens global credit will also have a negative impact across many global equity markets. 

The spatial relationship accounts for the integration of markets that will create higher correlation. There are financial and economic blocks which support higher correlation among equity markets. Global equity indices will still be driven by real GDP and real interest rates associated with the home country.

 

Once the common factor is identified within returns, there can be macro features which can be linked with the common factor. See the paper, "Assessing the international comovement of equity returns", which attempts to measure the common factor and the spatial factors in one model. They find that the common factor will have greater impact for open economies and more rigid exchange systems. 

If you are going to include international equity indices within a global macro framework, it is critical to measure and assess these common factor themes and not think about these equity markets in isolation. Even for following trends, it is important to track international common factors to distinguish between the equity index trend and a common trend across global equity markets. If the driver a common trend, then there is less diversification across positions.

 

Round trip for the summer - equity market environment is back to core stagflation story

What a difference between the optimism of July versus the reversal of August. The optimism was based on hope - the hope that the Fed would not have the resolve to continue to fight inflation in the face of a slowing economy. The market peaked the week before the Jackson Hole conference and then reset have Chairman Powell's comments. The SPX was down 408 bp in total return terms and has gotten worse since the new month began. Bond markets have not done much better. This has generated the returns for the 60/40 stock bond portfolio to be the worst recorded. There is again no safety with bond diversification.

As we enter the Labor Day holiday we are back where started after the Memorial Day week-end; a stagflation environment with a hawkish Fed. There were trading opportunities, but the global macro story has not changed and the world economy has gotten worse. There is little positive to look forward to in the months before winter.