OREANDA-NEWS. February 03, 2016. Central banks took center stage last week and made it clear that they are mindful of the downside risks to the global economy. The Federal Reserve delivered no new policy stance at its meeting, as expected. As the European Central Bank did the prior week, the Fed indicated that it is well aware of the recent turmoil in global markets. Of course, it would have been too soon for the Fed to do much more without damaging its credibility, having raised interest rates for the first time in six years just last month.

The meeting statement left open the possibility of a more gradual pace of rate hikes in the year ahead should the economy struggle. On Friday, it was the Bank of Japan’s turn, and it did act, lowering the deposit rate on excess reserves to -0.1 percent, joining the Eurozone, Denmark and Sweden in the negative interest rate club.

Stocks Move Higher to Close the Week, but Daily Volatility Continues

Equity investors liked what they heard and drove stocks higher. In the U.S., the S&P 500 gained 1.7 percent for the week on the back of a 2.5 percent climb on Friday. It was the second straight weekly gain, following two down weeks to begin the year, which trimmed its year-to-date decline to 5 percent. Stocks in the Eurozone rose as well, but by a more muted 1.0 percent for dollar based investors. And the Nikkei index rose 1.2 percent. The MSCI Emerging Markets index led the way higher with a gain of 3.6 percent in dollar terms.

Daily volatility remained elevated, in part because of currency fluctuations. The S&P 500 saw price movements in excess of 1 percent in four of the five trading days last week. As measured in euros, the EuroStoxx 50 index saw three days above 1 percent and two days above 2 percent. The Nikkei witnessed price movements in excess of 2 percent in three of the five trading days. The dollar was slightly weaker against the euro for the week. But after four days of relative stability versus the yen, the dollar soared by 2 percent on Friday, following the Bank of Japan’s move.

U.S. GDP Mixed; Emerging Markets Continue to Experience Weakness

The advance estimate of fourth quarter GDP rose at an annualized rate of just 0.7 percent. The component parts tell the story. Personal consumption slowed, but held up fairly well, as expected considering the improved condition of consumer finances. For all of 2015 personal consumption grew by 3.1 percent, the best since 2005. And overall GDP grew by 2.4 percent, matching 2014 as the best year since 2010’s 2.5 percent growth. But falling business investment exports and inventory liquidation took their toll in the quarter, driven by falling oil prices, dollar strength and sluggish overseas growth.

Much of that overseas sluggishness is centered in emerging markets (EM), as they come to terms with high debt levels, slowing growth, falling commodity prices and shrinking currencies. In the January update to its World Economic Outlook, the International Monetary Fund (IMF) now anticipates 3.4 percent global growth this year, down from the October forecast of 3.6 percent, but still an improvement from its 2015 3.1 percent estimate. In the U.S. the IMF sees growth of 2.6 percent, 1.7 percent in the Eurozone, 2.2 in the UK and 1 percent in Japan. For the UK this would represent growth in line with last year, but for each of the others these forecasts would represent modest improvement.

Among emerging markets, growth overall is also expected to improve from last year, from 4.0 to 4.3 percent. But aside from a few pockets of expected strength, including India and Southeast Asia, there are many trouble spots. Of course, China is slowing, and the adjustment is proving to be bumpy. The IMF forecasts a China slowdown to 6.3 percent growth this year, from 6.9 percent in 2015. Its slowing demand and the resulting fall in commodity prices is causing pain elsewhere. Brazil is forecast to remain in recession this year. Falling oil prices are slamming Russia as well, which is also forecast to remain in recession. South Africa is expected to slow to 0.7 percent growth from 1.3 percent.

Since April, the MSCI Emerging Markets index is down 22 percent in local currency terms. But in dollars, it is down 30 percent. For some countries, the currency depreciation is even more pronounced. For example, the Brazilian real began a steady decline versus the dollar, not-so-coincidentally, in April. The Bovespa stock index is down 29 percent since April 24 (in local currency), but down 47 percent (in dollars).

As revenues fall along with currencies, the explosive growth of debt in the emerging world since the onset of the financial crisis looks more daunting. This is especially true of dollar-denominated debt, which has grown increasingly expensive. The fear of rising default rates on loans and distressed bonds, and even a financial mishap at the sovereign level is contributing to global investor anxiety. The IMF calculates that non-financial corporate debt throughout the emerging world more than quadrupled in the 10 years through 2014, from \\$4 trillion to \\$18 trillion, and in the process growing from just under 50 percent of GDP to 75 percent. China has been the source of the biggest increase in debt, but Turkey, Chile, Brazil, India and others have levered up as well. These strains are made worse by a departure of capital.

So, how Concerned Should we be?

Citing data from the Bank for International Settlements and the Federal Reserve, the Bank Credit Analyst (BCA) estimates that U.S. bank exposure to emerging markets amounts is about 5 percent of assets. In Japan the exposure is roughly 3 percent of assets, while in the Eurozone it is roughly 7 percent, and in the UK about 8 percent. While not insignificant, these levels would appear to be manageable in the event of a crisis, especially given higher bank capital ratios.

Additionally, a deceleration in emerging market activity may have less of an impact on developed economies than generally believed. The IMF estimates that a 1 percent decline in EM economic growth would trim U.S growth by just 0.2 percent. The effect would be larger elsewhere, but only fractionally so, with the UK declining by approximately 0.25 percent, the Eurozone by 0.3 and Japan slowing by 0.35 percent. It should come as no surprise that China would account for roughly half of the effect. And as BCA points out, EM growth has already slowed from 7.5 percent in 2010 to 4.0 percent in 2015.

The other obvious question is whether or not the declines in emerging markets have left them undervalued and poised to outperform? The MSCI EM index trades at 11.4X trailing earnings. That compares to its five year average of 11.8X. Price to book value is currently at 1.27X compared to a five year average of 1.49X. But earnings have decelerated sharply. Last year they totaled \\$65.13 for the index, down 30 percent from their recent peak of \\$93.18 in 2013. Furthermore, earnings are expected to remain flat this year and next, according to Bloomberg. So, while valuations are nominally attractive, the macro environment is likely to remain challenging for the foreseeable future.

Important Disclosures:

The S&P 500 is an index containing the stocks of 500 large-cap corporations, most of which are American. The index is the most notable of the many indices owned and maintained by Standard & Poor's, a division of McGraw-Hill.

The Nikkei index is a price-weighted average of 225 stocks of the first section of the Tokyo Stock Exchange.

MSCI-All Country World Ex. U.S. Index: Is an unmanaged index representing 48 developed and emerging markets around the world that collectively comprise virtually all of the foreign equity stock markets.

The EURO STOXX 50 is a market capitalization-weighted stock index of 50 large, blue-chip European companies operating within eurozone nations. The universe for selection is found within the 18 Dow Jones EURO STOXX Supersector indexes, from which members are ranked by size and placed on a selection list. 

The Bovespa Index is a gross total return index weighted by traded volume & is comprised of the most liquid stocks traded on the Sao Paulo Stock Exchange.

The views expressed are as of the date given, may change as market or other conditions change, and may differ from views expressed by other Ameriprise Financial associates or affiliates. Actual investments or investment decisions made by Ameriprise Financial and its affiliates, whether for its own account or on behalf of clients, will not necessarily reflect the views expressed. This information is not intended to provide investment advice and does not account for individual investor circumstances. Investment decisions should always be made based on an investor's specific financial needs, objectives, goals, time horizon, and risk tolerance.

Investment products are not federally or FDIC-insured, are not deposits or obligations of, or guaranteed by any financial institution and involve investment risks including possible loss of principal and fluctuation in value.

Ameriprise Financial Services, Inc. Member FINRA and SIPC.