Global Macro Outlook for Emerging Markets

Emerging market economies and assets are sensitive to global U.S. dollar liquidity, the global economic cycle and the fluctuations of investor appetite for risk. The past decade has been one of relative strength for the U.S. economy in an environment of declining global growth. Relatively high returns on capital in the U.S. on both risk-free assets and stocks have sucked in capital from around the world and caused a prolonged cycle of appreciation of the U.S. dollar. These circumstances have been negative for emerging market asset prices and caused a decade of poor performance for stocks. Periodically, it behooves us to evaluate market conditions to ascertain whether circumstances are changing, and we do this by following a simple framework which considers:  Global U.S. dollar liquidity; currency trends; commodity prices; and risk aversion.

Global U.S. Dollar Liquidity

The chart below shows a measure of global U.S. dollar liquidity based on the evolution of  the combined values of (1) global central bank dollar reserves and (2) the U.S. M2 monetary base, data provided weekly by the U.S. Fed. The second chart shows separately global central bank reserves.  We can see from these charts the extraordinary nature of the times we are in.  The unprecedented increase in USD liquidity has been driven exclusively by massive money printing by the Federal Reserve, and this liquidity is finding its way into markets through fiscal spending and mandatory lending programs. This is in sharp contrast to the 2008-2009 (GFC) crisis when most of the increase in global dollar liquidity was caused by China’s infrastructure stimulus, which boosted commodity prices and underpinned international trade. In the current situation, international reserves have seen only a slight increase, but only because of some $700 billion in emergency swap lines provided to U.S. allies by the U.S. Fed.

 The U.S Dollar Cycle

The Fed’s unprecedented interventions made in concert with Treasury,  as well as gargantuan fiscal deficits, steep increases in U.S. government debt and the prospects of a sustained period of high fiscal deficits underpinned by financial repression (forced lending and negative real interest rates) may be unsettling the U.S. dollar. Debt levels in the U.S. are rising precipitously at a time when, for the first time in a decade, interest rates in the U.S. are no longer higher than in Japan or Europe and may no longer attract foreign capital.  Interestingly, the spread in favor of Chinese government bonds vs. U.S treasuries has been rising and is now at near record levels. The charts below show the DXY index, which measures the evolution of the U.S dollar primarily vs. the euro and the yen, and also the MSCI Emerging Markets Currency Index, which measures the value of EM currencies relative to the USD. The DXY has fallen from its March high of 103.5 to 95, breaking through the 50-day, 200-day and 18 month moving averages. This has happened concurrently with a sharp rise in the price of gold, which is further evidence that the confidence in the USD may be breaking. Nevertheless, for emerging market currencies, the breakdown of the USD is much less pronounced. Still, the recent weakness of the USD is certainly heartening for EM investors.

Commodity Prices

Commodity prices reflect both the value of the USD and global economic activity. At the same time, in recent decades they have been a key factor in determining global liquidity because major commodity producers typically sharply increase dollar reserves when prices rise. Rising commodity prices lead to significant increases in both global liquidity and domestic liquidity for many emerging markets, and they are generally necessary for asset appreciation throughout EM. The chart below, from Yardeni.com, shows the Commodity Research Bureau (CRB) Industrials Index, which historically has been highly correlated to emerging market asset prices.  We also show the chart for the spot price of copper, which has rallied strongly over the past two months. We can see from these charts – particularly the CRB Metals and copper – that industrial metals are on the rise. The likely explanation is the current surge in infrastructure spending by the Chinese government in a mini-version of the great 2008-2009 stimulus. These are bullish trends which further should improve investor appetite for EM assets.

Risk Aversion

Emerging market assets are considered high-risk investments that require a large risk premium.  In times of market turbulence, these premiums tend to expand dramatically. Emerging market premiums for both stocks and bonds are closely linked in their trading patterns to U.S. high yield bonds. The chart below, from Yardeni.com, shows the spread between U.S. Treasuries and U.S. high yield bonds. This is a very good measure of risk aversion, which serves for EM. We can see that these spreads have come down steadily since March. They remain at relatively high levels, but mainly because Treasury yields have collapsed. The question that investors have to ask themselves is whether market prices reflect reality at a time of unprecedented intervention by monetary authorities.

Conclusion

Though it may be early to call for the beginning of a new cycle of strong performance for emerging market stocks,  several signs are supportive of this thesis.  The recent weakness of the USD and the growing challenges for the U.S. economy may point to an extended period of  relative strength for emerging markets. Further USD weakness and commodity strength would support increasing exposure to EM assets.