By Michael Hasenstab, CIO of Franklin Templeton Global Macro
A vast set of valuation opportunities amid volatility
We recognise the challenges of the current market environment. Unfortunately, global markets appear to have been negatively impacted by the continued volatility in oil prices and the recent volatility in Chinese equity markets, along with the concerns for economic conditions in China and growth across the globe.
However, we believe there is a significant disconnect between the current market pessimism and the underlying global fundamentals. Markets have reacted as if conditions are worse than the 2008 global financial crisis, or the Asian financial crisis of 1997 and 1998, yet several emerging-market countries are in far better shape with larger foreign reserves and more diversified, growing economies.
The risk aversion across emerging markets appears to have reached a maximum state of unwarranted pessimism, in our view, and we see a vast set of valuation opportunities amid the volatility.
Are we headed toward global deflation?
In our assessment, market fears of deflation are unwarranted. The decline in headline inflation has been driven by the collapse in oil prices, yet core inflation has been positive and stable. When the oil price effects roll off the year-over-year inflation measures, statistically we will start to see headline inflation numbers pick back up.
Additionally, the US labour market is a key driver of inflation trends in the United States, which also drives inflation trends globally.
By our assessment, the United States is at full employment with growing wage pressures. We do not see imminent demand-side deflationary pressures, and we just don’t see any present empirical evidence of deflation.
We believe the levels of underlying inflation are underappreciated by the markets, and we anticipate a growing increase in the global output gap as emerging markets recover. In our view, there are more risks to inflation moving to the upside than to the downside, yet markets appear to be pricing in deflation and downside risks. We think inflation could surprise the markets.
China and market volatility
Markets have overreacted to conditions in China, in our assessment, and these fear-motivated responses are driving much of the broad market sell-offs. But, it’s important to separate what’s happening in the stock market from what’s happening in the actual economy.
The Chinese stock market is relatively new and volatile with a limited number of participants; it doesn’t represent the country’s entire economy. The actual underlying economy is going through a rebalancing, not a collapse.
There are swaths of China’s economy that are going into recession while other parts remain resilient and continue to expand. Investors in the old economy of China, such as the manufacturing and industrial sectors, certainly don’t feel a 6% growth rate; they feel negative growth.