Investors in emerging markets stocks started the year upbeat, expecting a two-year rally to continue. Market conditions appeared favorable. Valuations were low relative to the U.S. and other developed markets; and the global economy appeared strong, marked by “synchronized” growth across the developed world, China and emerging markets. Emerging markets also were expected to continue to benefit from rising commodity prices and a weakening dollar, both of which tend to occur during the later stages of the U.S. business cycle.
Unfortunately, by late-January the bullish thesis began to unravel.. The first sign of changes in the market environment was the sudden increase in volatility in the U.S. stock market. After the exceptionally low stock market volatility of 2017, the surge in volatility signaled a new regime of higher market risk. This was confirmed by a sudden appreciation of the U.S. dollar, a tell-tale sign of rising investor risk aversion. The first chart below from Credit Suisse show the remarkable increase in risk aversion that has occurred since late January. In the second chart , the JP Morgan EM Currency Index highlights the concurrent break in the two-year trend of dollar appreciation.
Concurrently with the return of volatility, during February economic indicators began pointing to unexpected slowdowns in economic activity in both Europe and China. This undermined the thesis of global synchronized growth. Worse, U.S. growth, fueled by enormous fiscal deficits in a late cycle economy operating at full employment, now appeared to be growing at a higher rate than the global economy. The chart below shows the worrisome slowdown experienced by China.
Also, early this year we saw an important radicalization of Trump’s “America First” agenda., with a strong rejection of traditional American diplomacy. In particular, his threats of engaging in trade wars with foes and allies alike has significantly increased risks to the global economy.
Finally, early this year markets have started to accept that the U.S. Fed is serious about the normalization of monetary policy. A new, less-dovish Fed governor and the inflationary impact of fiscal expansion and trade wars has convinced investors that monetary tightening is for real.
The new environment that has existed since February – relatively strong U.S. growth, Fed tightening and rising risk aversion – has triggered a strengthening of the U.S. dollar and a downtrend for EM equities. As the following chart from Ed Yardeni Research shows, as usually happens, emerging market stocks started to trend down at the same time that the dollar began to appreciate. The negative correlation of EM stocks with the US dollar (ie. EM stocks fall in local currency terms as the USD appreciates) significantly increases the volatility of the asset class.
The value of the dollar relative to EM currencies is a key indicator for EM equities, a rising dollar pointing to a move from investors way from high- risk EM securities to the safe haven of U.S. treasury bills. On the other hand, the two other key indicators to watch for emerging market equities – commodity prices and the spreads on high-yield bonds (U.S. and emerging markets) did not show initial signs of deterioration. In fact, as the charts below show both commodity prices and bond spreads have been stable since late January. It is only in recent weeks that both commodity prices and high-yield spreads appear to have started negative trends. The first chart, the Bloomberg Commodity Index, shows that commodity prices remained resilient through May, but have drifted down slowly since then. The second chart, from the Federal Reserve Bank of St.Louis, shows the difference in yield between high yield bonds and treasure bonds. This spread is a reliable indicator of aversion for risky assets and very negatively correlated to EM equities (as the spread goes up, EM equities fall).
Conclusion
For the time being, the trend does not favor EM equities, and a cautious stance is in order. If anything, the recent weakness in commodity prices and the rise in high yield spreads points to further troubles for EM equities. Nevertheless, for the medium term a more bullish stance is justified.
First, after the recent correction valuations are once again very compelling.
Second, by the end of this year a series of events weighing on the markets will have passed. The Chinese economy, which has been weighed down by official measures to deleverage corporations , is likely to see a rebound before the end of the year. In addition, the completion of a wave of elections in Turkey, Colombia, Mexico and Brazil will soon bring more clarity to policies for important EM markets.
Third, and perhaps most importantly, next year the U.S. economy is likely to slow down considerably, so that U.S. growth will no longer be higher than that of the global economy. As concerns rise with U.S deficits and the ageing business cycle, dollar weakness may resume.
In conclusion, keep your powder dry as 2019 may be a much better year for EM equities.
Fed Watch:
India Watch:
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China Watch:
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EM Investor Watch
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