Caution Remains in Order For Emerging Markets

 

Financial markets have rallied strongly since the “Christmas Eve massacre.”  Since the December bottom, the S&P 500 has rallied 17% and emerging markets are 10% higher. Wall Street has put a positive spin on Fed Chairman Jay Powell’s sudden pivot to the dovish camp, and the bet is that a soft landing for the U.S. economy will be achieved. President Trump’s eagerness to sign a trade deal with China  also has lifted spirits.

For emerging markets, however, we have mixed signals and caution is still advised.

First, it may be that Wall Street,  for the time being, has interpreted the Fed in too optimistic a manner. The Fed’s pivot may be an indication that the interest rate cycle has peaked and that the next move in interest rates is down. This would not be bullish for EM equities, which tend to do well when the economy is over-heating and the Fed is raising rates (2016-2018) but then do poorly when the cycle turns. The Fed’s own recession probability indicator has shot upwards recently, even before the very poor December retail sales numbers released this week. This rising fear of a slowdown is seen also in Duke University’s CFO survey, which has 75% of CFO’s expecting a recession by 2020. This becomes a self-fulfilling prophesy, as CFO pessimism drives down investment and hiring plans.

Second, EM assets appear to be  in overbought territory. There has been a strong inflow of funds over the past two months into the three main EM asset classes: equities, local currency bonds and dollar-denominated bonds. Bonds started to rally before equities, an indication of increasing appetite for EM yield, as expectations for U.S. rate increases collapsed. Interestingly, according to Merrill Lynch’s survey of fund managers, EM equities have gone from the most shorted to the “most crowded trade” over a three-year period. The table below shows that today is the only time over the past five years that portfolio managers have been so keen on EM equities. Portfolio manager positioning tends to be a strong contra-indicator. In March 2016, at the lowest level since the great financial crisis and right at the beginning of a powerful rally for EM equities, Merrill’s survey identified being short EM equities as their highest conviction trade for portfolio managers.

Another indication that the markets may be overbought can be see in the following chart from Goldman Sachs. The chart shows a very unusual situation where EM assets have appreciated sharply in the face of deteriorating economic conditions.

In addition to the current overbought condition of EM, there are several additional indicators that merit investor attention. These are: dollar strength, commodity weakness and global liquidity.

Historically, EM assets sustain rallies when (1) the global supply of dollars is high, (2) the dollar is trending down (weakening relative to EM currencies) and commodities are appreciating.

Not one of these indicators is currently positive.

Global Liquidity

We can look at several indicators of the supply of dollar liquidity in international markets. These are shown below.

First, global dollar liquidity as measured by U.S. M2 plus international dollar reserves. This indicator moves up in December, but remain in depressed territory.

Second, International dollar reserves, which are still trending down.

Third, Ed Yardeni’s “Implied International Capital Flows,” which is in a sharp downtrend.

Fourth CrossBorder Capital’s “Emerging Markets Liquidity Cycle” which also is in a sharp downtrend.

The Dollar Trend

The dollar continues to strengthen relative to EM currencies.

First, the EM MSCI Currency Ratio, which continues in a major downtrend. The index has ticked up recently, only because it is heavily weighted in China, where the yuan has stabilized on trade-talks optimism.

Second, both the DXY dollar index (heavily weighted to developed currencies) and the equally weighted EM index show the dollar strengthening trend to be persistent.

 

Commodities

The CRB Raw Materials index measures prices for a broad variety of industrial inputs. Historically, this index has the highest correlation with EM equities. Following a strong rebound in 2016-2018, the index has resumed the downtrend started in 2012.

In conclusion, after the recent rally in EM assets, some caution is warranted. For investor optimism to be rewarded, it is important that the three pillars of EM asset prices (global liquidity, the dollar and commodities) turn favorably. Perhaps the greatest cause for bullishness would be a conviction that China’s efforts to stimulate its economy through fiscal and monetary measures will bare fruit during the course of the year. So, investors should focus keenly on the data coming out of China.

Trade Wars

  • A look at the future of Sino-U.S. relations (Li Lu Himalaya Capital)
  • The internet has become a battleground between the U.S. and China (WSJ)
  • Senator Rubio’s report on the China threat (U.S. Senate)
  • Is China or Russia are new rival (The Atlantic)
  • China, an existential threat for the 21st century (NYT)
  • New Zealand feels China’s anger (NYT)
  • The trade war is only about theft of technology (Project Syndicate)

India Watch

  • India curbs create chaos for Amazon and Walmart (Bloomberg)
  • India’s big upcoming election (Lowy)
  • India’s vote-buying budget (Project Syndicate)
  • India looks to China to shape mobile internet (WSJ)
  • Amazon adapts to India (WSJ)
  • India’s love of mobile video (WSJ)
  • India’s potential in passive investing (S&P)
  • India’s food-delivery startup, Swiggy, backed by Tencent (SCMP)
  • Modi’s election troubles (WSJ)

China Watch:

  • Haier’s turnaround of GE Appliances (Bloomberg)
  • China’s consumer is losing confidence (WSJ)
  • China real estate bubble (Nikkei)
  • Will China fail without political reform? (Project Syndicate)
  • S&P gets go-ahead to issue China debt ratings (WIC)
  • Stable growth expected for China’s Economy (AMP Capital)
  • China’s infrastructure spending to boost economy (SCMP)
  • The new Beijing-Moscow axis (WSJ)

China Technology

  • CTrip’s strategy (Mckinsey)
  • DJI’s rise (SCMP)
  • China’s decade-long Bullet-train revolution (WIC)
  • China’s lead in EVs and EV infrastructure (Columbia)
  • China’s high-flying car market (McKinsey )
  • China’s place in the autonomous vehicle revolution (McKinsey)
  • Can China become a scientific superpower? (The Economist)

Brazil Watch

  • Brazil’s finance guru (FT)
  • The rise of evangelicals in Latin America (AQ)

EM Investor Watch

  • Globalization in Transition (mckinsey)
  • World Bank Report, Global Economic Prospects (World Bank)
  • Indonesia’s economic populism (The Economist)
  • EM’s Corporate debt bomb (FT)

Tech Watch

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