The end of the quarter is not the end of the rout

Outlook:

We got a respite from risk aversion yesterday but it was still the worst quarter for equities since 2011. The Shanghai led, down 25%. The Dow closed the quarter down 7.6%, the S&P, down 6.9% and the Nasdaq, 7.4%. The WSJ reports investors pulled $40 billion from emerging-market stocks and bonds in the quarter, the biggest outflow since Q4 2008. The developed world markets were led by emerging market markets. The MSCI Emerging Markets Index fell 20% through Tuesday and the MSCI World Index fell 9.3%.

EM currencies were leaders, too. “Among the worst-performing currencies in the quarter were the Bra-zilian real, which fell 22% against the dollar; the South African rand, which weakened 12% and the Ma-laysian ringgit, which slid 14%. These countries are the biggest commodity suppliers to China, and are suffering from a double whammy of a downbeat demand outlook and lower commodity prices. The S&P GSCI, an index that tracks a basket of 24 commodities, in late August hit its lowest in more than six years and remains near that level.”

Unless we get some hard evidence that China has indeed bottomed out, it is too soon to say the end of the quarter is the end of the rout. Several equally plausible scenarios could be coming, from an immedi-ate resumption of fear and a Q4 to match Q3, to a tapering off of fear and gradual recovery into year-end and end-Q1 2016. Or something in-between. At a guess, we will be evaluating the Chinese economy and prospects from now on, more or less permanently. It’s rude to say so, but Brazil (or Russia) can go to hell in a handbasket and it won’t necessarily have an effect of developed country markets. But if Chi-na seems to worsen, everybody has to watch out.

This is one context in which a Fed rate hike is a soothing factor. The reasoning would go something like this—“See, the world’s largest economy is thumping along on all cylinders and it’s okay if China is drooping a bit. Drooping is only to be expected… No country can sustain double-digit growth for-ever.” This would constitute a normalization of sentiment based on real economy factors and some historical perspective.

And since China doesn’t want to be seen as the source of global financial market distress, we may get better data even if it’s not true and we may also get a lot less ham-fisted control-economy measures than we saw in the equity market in August. China is very, very smart (unlike, say, Venezuela). If a primary goal is to appear to be managing the transition to a consumer-oriented economy properly, we can bet the Chinese will make appearances convincing.

Now it’s up to the US economy to deliver confidence-inspiring data. Today’s data includes the Chal-lenger layoff report and the ISM PMI, as well as auto sales and the usual Thursday jobless claims. We have a couple of Fed speakers (Williams and Lockhart). Mr. Draghi speaks at the Museum of Natural History in NY tonight at a shindig of the Atlantic Council Global Citizens Award. Those honored this time include the president of Afghanistan, the president of Lockheed, a US general and a country singer. Kissinger is also named as a 2015 honoree. This is a useless exercise and you have to wonder why Draghi is there at all. That so many analysts are naming his presence at the event reveals that we all yearn to hear more from Mr. Draghi about any topic at all.

Let’s stop worrying about China and about equities for the moment and return to what really counts—that pesky bond market. Market News notes that at the close (around 2.060%), “Ten-year yields re-mained below the 200-day moving average, currently around 2.119%. As background, 10-year yields topped around 2.303% September 16 and bottomed near 1.905% August 24, the day of the big China stock sell-off, the lowest yield seen since April 27th. At the height of bond selling seen in early summer, 10-year U.S. yields saw a high of 2.50% June 11.” We may not need a big rise in yields to solidify senti-ment that the US economy really is okay, but we almost certainly do need a halt in this silly volatility. See the chart.

With any luck, tomorrow’s payrolls will calm things down. ADP has the private sector job growth at 200,000, which is the Market News number for the entire job number. Unless the public sector adds zero jobs, that implies the private sector number could be a lot lower. And we have some analysts moaning about a deceleration in job growth. Some of that is a loss of jobs in the energy sector. But hey, it’s still growth, and shortages of skilled labor continue to get a headline or two.

At an important tidbit, Market News reports that the IMF released reserve data yesterday—a global total of $11.460 trillion at the end of Q2 2015 from $11.435 trillion in Q1 2015. So-called allocated reserves are higher, too. China is increasingly reporting its allocations and will offer full coverage within two-three years. It is currying favor with the IMF.

We say one of the important data points in the report is the breakout of which currencies are reserve cur-rencies. The dollar gets a 63.8% share of total allocated reserves, down a little from 64.1% in the first quarter. Euros have a 20.5% share in Q2 from 20.8% in Q1, according to Market News. We don’t know who picked up the slack—sterling? Yen?—but probably the main point is that the doom-and-gloom crowd saying the dollar is being pushed out are still wrong. And assuming Europe returns to decent growth without a deflation crisis—and we do make that assumption—euro-buying for reserves can pick up.

Finally, let’s say the dollar rallyette continues today and tomorrow, even if the dollar founders against the Other Dollars and commodity currencies (peso). So what? We need to ask whether it has lasting power. For that we might want to watch the dollar/yen, which is going nowhere for the past month (a bit like oil). If the dollar gains against the yen in any significant way, we might think yield differen-tials are in play again at last. The problem is that the yield differential has been such an unreliable factor. Divergence in other currencies against the dollar may mean nothing at all for the longer-term out-look. Even if we get a euro dip to the round number 1.1000 or the last significant low (1.0809 from July 20), it will still be just a gyration (and a messy chart), not signifying clarity about the global economy. For that we need the Fed.