The most active ETF for emerging markets, EEM, sold off sharply along with nearly all equity classes on Black Tuesday, as they are calling it in China we gather.
It is instructive to note the two prior warning signs of a potential sell-off from the May 2006 corection, as well as the recent downdraft in January. This shows up most clearly on the weekly charts. Clearly there is every chance that what we are now seeing is another version of a short, sharp move down across all equity classes, especially higher risk ones. Equally, the chance of something more lasting and severe is always there. (eem_w_280207.pdf)
One key difference from the May 2006 correction is that last year prior to the fall in equities bond yields had moved up over 50 bps (0.5%), whereas recently yields have fallen. This has the effect of widening the spread between real yields on bonds and real yields on equities (or the earnings yield), creating a self-correcting cushion for the equity markets, as long as confidence in the earnings cycle remains more or less intact. Another major factor remains the ultra low spreads between corporate bonds and government bonds, providing ample fuel for further buybacks, mergers, LBOs or even capital spending. In May 2006, the fear was all to do with inflation and higher rates choking off growth around the globe.
It would be ironic if the central banks who are still raising rates - UK, Japan - and talking a tough game on inflation were in fact fighting last year’s war.
