So much for the rally

When we asked last week about the quality of the rally in equities, we didn’t expect markets to provide an answer so quickly. The brief spell of optimism ended abruptly at the end of last week as European banks’ funding problems continued and the eurozone reported weak economic data, prompting equity markets worldwide to slump, gold prices to touch record highs and Treasury yields to tighten even further.

The grim mood continued yesterday as the reporting season got underway in China. Stocks in Hong Kong took a beating during the day and only a rally in HSBC rescued the Hang Seng index from a loss for the day. In Singapore, weak exports are pointing to a technical recession there and Bank of America Merrill Lynch on Friday raised the probability of a recession in the US from 35% to 40%.

But the overall picture is one of confusion and uncertainty rather than outright pessimism. BoA Merrill’s biggest concern for the US is an “uncertainty shock”, suggesting that businesses are frozen with fear and unsure whether to invest or cut back, but the bank is still predicting a soft landing for Asia.

POLL RESULT Is the recovery in stock markets real? Yes, the panic is over  10% No, it's just a temporary effect  56% It's anyone's guess  34%

“While the developed world stumbles, emerging markets seem to be slowing gracefully,” it said in a report published yesterday. “Chinese activity data have shown resilience over the past two months, backing our base case for a soft landing in China. Asian export growth is also treading a soft-landing path. Moreover, this restrained response of the macro data is aligned with what we are seeing in local markets. The BofAML aggregate of Asian currencies has lost only 1% since its recent peak. And capital flows continued to favour local debt funds despite rising volatility in global markets. Our strategists interpret these as signs of a transformative year for Asian fixed income and FX markets. Are EM economies becoming less sensitive to global shocks?”

BoA Merrill’s analysis suggests that emerging markets are showing less sensitivity to volatility in the US compared even to two years ago. But the risk of recession in both Europe and the US is nevertheless rising, and such an outcome would clearly make it almost impossible for Asian markets to avoid a similar fate.