The first half of 2022 has been another big disappointment for investors in emerging markets as EM stocks fell 17%. On the positive side, EM stocks did better than the S&P 500, which fell by 20% during this period. Unfortunately, the rest of the year does not look better. The environment is simply not positive for EM assets. I wrote in February that Winter was coming (link) ; now we can say that we are in the thick of winter.
All the indicators that we look at to mark the investment climate point firmly to more trouble ahead. Let’s look at these one by one.
- King dollar – EM assets usually do poorly when the dollar strengthens, mainly because most EM countries are short dollars and because commodity prices tend to do poorly during these times. The dollar has been strong since 2012, and this has been an awful period for EM investors. The recent surge in the dollar caused by high global risk aversion and flight of capital into U.S. assets, is a huge headwind for EM. The charts below show first the DXY (heavily weighed towards the euro and the yen) and second the MSCI EM currency index, both of which show the sustained run the dollar has had for 10 years.
2. Global dollar Liquidity – Risky assets like EM stocks and bonds do well when dollar liquidity is ample and poorly when it dries up. After the money printing orgy of 2021, the tide has ebbed. The charts below show: first, one measure of global liquidity (U.S. M2 plus central bank reserves held at the Fed); and second, central bank reserves held a the Fed. Liquidity is now in free fall. Foreign reserves held at the Fed are also plummeting, as countries like China and Russia have dramatically reduced their positions for geopolitical reasons and other countries are fleeing the negative real yields of Treasury notes.
3. Yield spreads – The spread between the yield of U.S. high yield bonds and Treasury bonds is one of the best indicators of risk aversion and recession risk. Historically, rising spreads point to problems for EM. We can see in the next chart the recent rise in the spread. Moreover, the rise in the spread has been tempered by the benefit of high oil prices for oil companies. Stripping these out the spreads would be much higher.
4. The CRB Industrial Index – Commodity prices and in particular industrial commodity prices are a tried and true indicator ofmarket trends for EM assets. This has been even more so since the rise of China twenty years ago because China is the primary consumer of industrial commodities, and any slowdown in China now spreads rapidly to the rest of EM. The CRB index, shown in the chart below from Yardeni.com, has turned down since February and now appears in free fall. The combination of high oil prices and low industrial metal prices is a very bad one for EM.
5. Copper price – Finally, the price of copper is a good indicator of global economic activity, as Dr. Copper is known to sniff out recessions earlier than most economists. Unfortunately, copper also appears in free fall now.
So, all the relevant indicators tells us we are in a winter storm. It is best to sit be the fire with cash in hand and wait for calmer times.