Mixed bag weighs on regional markets

But despite recent declines, 2017 has been a good year emerging markets, up nearly 32 per cent since the start of this year

A trader in the S&P 500 pit at the Chicago Board Options Exchange. Market shock may be looming. Bloomberg

Both global and regional equity indices have declined over the last week, albeit to varying degrees.

After reaching a record high on November 8, the S&P 500 index lost more than 1.5 per cent, before recovering somewhat to end last week 0.5 per cent lower than its peak. This was despite relatively strong third quarter earnings and more firms revising their forward guidance higher than lower (according to data compiled by Bloomberg). In Europe, the Stoxx600 index fell nearly 2.8 per cent over the same period.

Several factors probably contributed to the most recent bout of risk aversion, including lower commodity prices (including oil), uncertainty about US tax reform, Venezuela’s debt default and a sense among many institutional investors that equity valuations, particularly those in the US, may be stretched. Year-end profit taking after a strong run this year may also have contributed to the pull-back last week. Despite the recent declines, 2017 has been a good year for global equities - the MSCI G7 Index is up 15.8 per cent year-to-date, and emerging markets have done even better, up nearly 32 per cent since the start of this year.

Recent economic data suggests that the fundamentals remain strong. Preliminary estimates for third quarter GDP in the euro zone and Japan showed solid expansion, with euro-zone growth likely outpacing both US and the UK growth this year. Nevertheless, there are risks ahead, not least from tighter monetary policy in the world’s largest economy. The US Fed is expected to raise its benchmark rate for the third time this year at its next meeting in December, and the Fed’s own projections show another three rate hikes pencilled in for 2018. This extent of monetary policy tightening is not currently priced into the market.

The UK recently increased its benchmark interest rate for the first time since the global financial crisis and, although the Bank of England did not indicate that another rate hike is likely in the near term, inflation in the UK remains a full percentage point above the bank’s 2 per cent target. Even the European Central Bank has signalled that it is unlikely to continue with asset purchases beyond September 2018, implying a (gradual) tightening in the monetary policy stance in the euro zone, too.

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Another headwind for financial markets is geopolitical risk, which remains elevated, and not just in our region. In the near term, there is still uncertainty about the timing and scope of US tax reform, with the Senate and House versions of the tax reform differing in key areas such as the timing of the proposed corporate tax cut (to 20 per cent from 35 per cent currently), the number of tax brackets and which existing tax breaks will be eliminated. It is entirely possible that the final version of the tax reform is not approved until the first quarter of next year, and that it may not meet market expectations in terms of boosting US growth next year.

In Europe, Brexit talks are reaching a critical point and it’s unclear if enough progress will be made to open trade negotiations at the December summit. The key issues of how much the UK will pay the EU, the Irish border and rights of EU citizens in the UK are still unresolved, with both sides expecting the other to compromise. At the same time, the UK prime minister Theresa May’s position domestically is increasingly embattled, with two cabinet resignations in the past fortnight and opposition from within her own party to fixing the date of the UK’s withdrawal from the EU in the Brexit legislation.

The escalation in geopolitical tension in the Middle East since the beginning of November has had an impact on regional equity markets, although data shows that regional equities have underperformed their global peers year-to-date, not just in recent weeks. Nevertheless, the most recent escalation in political risk in the Middle East has resulted in investors reducing their exposure to GCC equities. Flow data for the Saudi Tadawul shows that foreign, GCC and Saudi retail investors were net sellers to the tune of 1.1 billion Saudi riyals (Dh1bn), 770 million riyals and 3.5bn riyals, respectively, in the week immediately following the Saudi anti-corruption crackdown.

It appears that the increased geopolitical uncertainty in the region has outweighed the positive impact of higher oil prices on GCC budgets, as well as the encouraging Purchasing Managers’ Index survey data which has shown a solid expansion in the non-oil sectors of the UAE and Saudi Arabia in recent months.

Khatija Haque is head of Mena research at Emirates NBD