Conclusion: As Slowing Growth gets incrementally priced into equity markets globally, we are starting to uncover some interesting opportunities across emerging markets on the long side.
As a point of clarification on how we manage Global Macro risk, we don’t typically subscribe to the convenience of lumping together random economies for storytelling purposes. That being said, however, we’re happy to step outside of our shell on a late Friday afternoon to quickly illustrate a point that you’re going to hear us make with increasing volume in the coming weeks and months:
Deflating the Inflation is especially good for those emerging markets which have underperformed on a 6-12 month basis – from both an economic and equity market perspective.
Less simplistically, we are of the view that as commodities continue to break down across the board (particularly in the food and energy complexes), downward pressure will be applied to emerging market CPI readings, which are typically more levered to food and energy prices than their developed counterparts. That provides cover for those central banks which have proactively tightened monetary policy over the last 12-18 months to become dovish on the margin. As Keith pointed out in today’s Early Look, China remains our go-to in this setup.
Be it coincidence or Chaos Theory, it’s no surprise to us that the CRB Index peaked YTD on the exact same day as the US Dollar Index found its YTD bottom (slightly above its all-time low). From a quantitative perspective, the CRB Index remains broken on our intermediate-term TREND duration, while the US Dollar remains bullish on our immediate-term TRADE perspective.
Regarding the US Dollar specifically, it remains the dominant factor in our Global Risk Management Model and we have been fortunate in making many accurate calls on the US Dollar since our firm’s inception over three years ago. Now, we are bullish on the US Dollar from a research perspective and this view is supported by the following factors:
- The end of QE2 means the growth of the Fed’s Balance Sheet will no longer be a headwind (positive on the margin);
- We don’t believe QE3 is in the cards, but assuming that consensus will clamor for more “stimulus”, the timing of any hint from the Fed is likely six-plus months away (refer to our Indefinitely Dovish and What’s Next for the Fed? presentations for more details);
- A shift on the margin towards fiscal sobriety in Washington, D.C. via a Debt Ceiling Compromise is also a bullish catalyst for America’s currency;
- Slowing growth in the Eurozone will have the FX market pricing in less and less hawkishness out of the ECB relative to the Fed on a go-forward basis (don’t forget that the socialist Mario Draghi takes over in November and the Europeans have a full 125bps of potential interest rates to cut). EUR bearishness is USD bullish (57.6% of DXY basket).
Net-net-net, we’re bearish on commodities and bullish on the continued unwinding of the Inflation Trade (the naming of which we appropriately authored in 4Q10).
As Slowing Global Growth continues to get priced into equity markets broadly, we expect investors to stop paying a premium for growth they hope is there (US equities) and to start paying a premium for whatever growth they can find. Hope is not an investment process. Neither is relative value from a longer-term perspective, but we agree that such a strategy can indeed work on shorter durations between cycles.
The price action we’ve seen on a global basis throughout the last week is supportive of our call. Of the 95 equity indices we track (75 countries, 9 S&P 500 large-cap sectors, the MSCI EM Index, and 10 MSCI EM sectors), China’s Shanghai Composite is leading the way at +3.9% on a week-to-date basis. In full disclosure, we are long Chinese equities in our Virtual Portfolio (since June 16). More broadly speaking, the top quartile of wk/wk performance is dominated by EM exposure at 71% of the total. We expect that number to creep higher in the months and weeks to come – particularly as bombed-out markets like India’s SENSEX and Brazil’s Bovespa (down -12.7% and -16.4%, respectively, since the start of QE2) start to recover after deceleration in their domestic growth rates is fully priced in.
As the charts above suggest, now is not the time to cannonball into emerging markets broadly from a quantitative perspective. Each country will initiate its own bottoming process based on the slope of growth, inflation, and monetary policy within its borders. For now, we think China represents the best opportunity on the long side. We’re happy to walk through our Year of the Chinese Bull thesis and/or any other countries with you; just shoot an email to .
One final point we want to make before we wrap up is that it will likely prove prudent to stay away from those emerging markets whose economies are levered to rising commodity prices on the long side. If anything, we would be looking to short petrodollar markets like Russia. For more details on our bearish thesis on Russia, refer to Matt Hedrick’s June 23rd post titled, “Russia From 30,000 Feet”.
Best of luck out there,