The Global Liquidity Cycle and Emerging Market Stocks

Investing in emerging market equities often requires an understanding of global liquidity cycles. There are two main drivers of global liquidity. First, in a world financial order that is largely U.S. dollar-based, the fiscal and monetary policies of the United States have great influence on global capital flows. Second, in times of heightened financial and political risks, the United States, with its highly liquid markets and rule of law, is seen as a “safe haven.”  When conditions draw international flows into the U.S. financial system, the dollar appreciates. These periods are known as “risk-off” periods, which means that  investors prefer the security and safe-haven nature of the U.S. markets over more volatile international markets. On the other hand, there are times when conditions in the United States become relatively unattractive to investors. During these “risk-on” episodes international investors seek the higher returns available in riskier financial markets like those of the emerging markets. During these periods, the dollar tends to depreciate, while the asset prices of emerging markets rise in value.

USD “risk-off” periods occur when return expectations are higher in the U.S. This is generally because of a combination of higher risk-adjusted returns on financial assets and higher GDP growth. We are currently in such a period. Until January of this year, it appeared that growth outside the U.S. was accelerating, and this was reflected in a weakening dollar. But the market narrative changed swiftly when signs appeared of slowing growth in Europe and China. Soon after, several emerging markets (Brazil, Argentina, Turkey) suffered significant economic setbacks. Global financial risks also rose because of political tension in Italy and concerns with the consequences of a “hard Brexit.” Moreover, an assertive U.S. foreign policy relying heavily on trade war threats and sanctions increased uncertainty.  As world growth sputtered, the late-cycle U.S. economy accelerated, fueled by tax cuts. Concurrently, the U.S. Fed sustained its commitment to raise rates. A   relatively strong U.S. economy with rising rates is very much a “risk off” mode and not surprisingly the dollar has appreciated since January. The rising dollar because of its dampening effect on inflation has also raised the prospect of a further extension of the U.S. business cycle.

During “risk off” periods global liquidity is drawn to the U.S. market, as capital seeks a safe haven.  As the tide of global liquidity ebbs, the most vulnerable merging markets are caught naked. The typical victims are those countries that have a high level of dependence on short-term cross-border financing, usually because they have indulged in a combination of elevated current account and fiscal deficits financed by short-term dollar debt. The current roster includes Turkey, Argentina, South Africa, Indonesia and Brazil. As is often the case, political uncertainties make a bad situation worse, as we see today in Turkey and Brazil.

Emerging markets experience shorter and sharper cycles than the United States. This is intrinsically linked to the nature of the global liquidity cycle. During emerging market downcycles, dollar appreciation accentuates corrections.  At the same time, policy makers are forced to implement pro-cyclical policies that further deepen the downside. A rising dollar acts like a combination of a tax increase and tighter credit, while also driving inflation higher. This is the situation today in Argentina and Turkey where markets (with or without the support of the IMF) are demanding large pro-cyclical adjustments at a time of extreme currency weakness. During upcycles, the opposite happens: currency appreciation and pro-cyclical policies turbo-charge the economy. A weak dollar usually signals world economic expansion and acceleration, and expanding credit.

The U.S. economy exists in a very different environment. The U.S. has  much greater control over its destiny and much longer business cycles, with the overwhelming fundamental advantage that policy makers have both fiscal and monetary tools available for counter-cyclical measures. The current U.S. business cycle, which is now the longest in history, has been made possible by a persistently strong dollar and unprecedented counter-cyclical policies, reaching a climax with President Trump’s massive tax cut. This extended cycle has been made possible by the strong dollar’s repression of inflation.

The end of the current liquidity cycle should bring about the next bull market for emerging market economies and asset markets. This will likely occur in the next 12-18 months as the U.S. business cycle finally exhausts itself. The short-term beneficial effects of Trump’s fiscal expansion and trade policy will wear off, leaving behind more debt and higher inflation. At the same time, U.S. monetary policy will gradually “normalize.” Dollar cycles tend to last 5-8 years. When the cycle eventually turns, a weaker dollar will drive inflation higher in the United States.

The charts below show how tied the investment and dollar cycles are in emerging markets. The first chart, from Yardeni Research, shows the MSCI Emerging Markets Currency Ratio (US$/local currency). This reveals the evolution of the implied exchange rate of a basket of currencies representing the country weights in the MSCI EM index. The index shows three clear periods: 1995-2002 (seven years of dollar strength; 2003-2011 (eight years of dollar weakness; 2012-2018 (six years of dollar strength).

The second chart shows the performance of a global index of emerging market stocks. EM stocks are shown to be a turbo-charged version of the dollar-index, doing well in times of dollar weakness and poorly when the dollar strengthens. Note that the EM equities rally of 2016-17, came to a brutal stop when the dollar resumed its rise. The third chart (capital spectator) illustrates more clearly the negative correlation between EM equities and a rising dollar.

The following three charts show the best two measures we have of how global liquidity is impacting emerging markets. The first chart shows the accumulation of US dollar assets by foreign institutions (ie. Central banks, sovereign funds). These funds come mainly from emerging market central banks that accumulate dollar reserves to stabilize their currencies during periods of sustained dollar weakness. These reserve accumulations are closely linked to episodes of elevated credit expansion because authorities are not willing or able to neutralize the impact on money supply. The second chart, from Gavekal Research, adds the U.S. monetary base to foreign central bank reserves to come up with an estimate of total global US dollar liquidity, which Gavekal calls the world monetary base (WMB).

We can see in these charts a repetition of the pattern we saw above with regards to the dollar and emerging market equities. During period of dollar strength (1995-2002 and 2012-2018) foreign reserves fall in real terms (leading to credit contraction) and poor performance for emerging market assets. Global liquidity contracts during periods of dollar strength, dampening growth prospects in emerging markets. My own data shown in the last chart  (M2 plus foreign assets held at the FED), updated through July 2018, shows a sharp fall in global liquidity since January of this year, signaling further pressure on emerging market assets prices.

Macro Watch:

• Emerging vulnerabilities in emerging economies  (Project Syndicate)
• The end of the bull market for stocks (Project Syndicate)
• Germany call for European SWIFT (FT)
• The markets are waving a huge red flag (seeking alpha)
• Ed Yardeni’s a bit more cautious (Yardeni)

India Watch:

• Buffett invests in India payments platform (WSJ)
• India’s growing clean air lobby (BNEF)

China Watch:

• The rise of China’s super-cities (HSBC)
• China’s urban clusters fuel growth (Project Syndicate)
• Japan auto makers look to China (WSJ)
• Is China really slowing? (PIIE)
• The great Chinese art heist (GQ)
• Thoughts from my Beijing trip (Sinocism)

China Technology Watch

• China’s authoritarian data strategy (MIT Tech Review)
• China leads in CRISPR embryo editing (Wired)
• China’s EV start-ups forced to seek state partners (QZ)
• How WeChat conquered China (SCMP)
• Why do Western digital tech firms fail in China (AOM)

EM Investor Watch

• Brazil’s nostalgia for dictatorship (NYT)
• Turkey’s problem is not going away (Bloomberg)
• Erdogan’s power grab (FT)
• Malaysia rejects China “colonialism” (SCMP)
• The new arab world order(Carnegie)
• A history of EM bear markets (Wealthofcommonsense)
• Turkey’s secular young are losing the country (Ft)

Tech Watch

• China and Japan agree to EV charging standard (Nikkei)
• Drones in mining (Youtube)
• The future of batteries (Wired)

Investing

• Li Lu’s lecture at Beijing University (Himalaya Capital)
• Charlie Munger and Li Lu Interview (Guru Focus)
• Interview with Bill Nygren (Youtube)
• The 8 best predictors of market returns (WSJ)