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Takeaway: The time will come to aggressively fade the current relief rally/dead-cat bounce(s) across EM asset classes.

SUMMARY BULLETS:

  • In our most recent globally-interconnected macroeconomic scenario analysis, our #EmergingOutflows theme should continue trending relatively unabated in three of the four most probable outcomes with respect to the TREND duration (NOTE: not all probabilities are the same):
    1. The Chinese economy continues to suffer from structural financial sector headwinds: that would be a clear headwind to EM investor sentiment and EM economic growth;
    2. US economic growth markedly accelerates: that would keep our US monetary renormalization theme (i.e. #StrongDollar and #RisingRates) firmly intact, which has historically been the death-knell for EM asset classes;
    3. The 2013 bears get what they’ve been calling for the entire way up and the US economy finally implodes: That would be a headwind to global risk taking sentiment and liquidity. In that scenario, we’d likely see broad-based asset price deflation and a demonstrably stronger USD on a flight-to-perceived quality in the US Treasury market.
    4. Just about the only scenario where we see EM assets meaningfully rebounding from here is a TREND-duration inflection in US growth expectations that brings about an explicit promise of more QE from the Fed. Quantitatively speaking, neither the US Dollar Index, US Treasuries nor Gold view that scenario as a probable outcome at the current juncture, but we will change as the facts do.
  • For now, we remain the bulls on the USD and the bears on Gold. We also hold the axe on emerging markets and are inclined to keep chopping away on the short side. Specifically, there’s +2.9% upside to the EEM’s immediate-term TRADE line of resistance and +8.8% upside to the TREND line from last price. Barring scenario #4 as laid out above, we would short EM equities with impunity if they were to bounce all the way up to the latter of the two resistance levels.

EM OUTFLOWS ACCELERATE… TO AN ALL-TIME HIGH!

According to data from EPFR Global, emerging market equity funds saw $5.6B of outflows in the week-ended JUN 26, good for the fifth consecutive week of outflows. The four week total for JUN-to-date came in a $19.9B, which set a new record for monthly outflows, surpassing the previous record of $18.7B in JAN ’08.

Two quick points to make in light of this data:

  1. Anyone who bought EM stocks hand-over-fist in JAN ’08 because they were “cheap” probably is: A) not necessarily inclined to do so now (scar tissue); or B) no longer around to do so this time around.
  2. EM stocks are not “cheap”.

Regarding point #2: Even after the recent bloodbath across the EM asset allocation spectrum, EM stocks are still only roughly in line with their historical mean valuations when analyzed on a relative basis to DM equities (NOTE: we pulled the charts back as far as we can find comparable data (i.e. 1999)). Net-net, “cheap” can get a lot cheaper from here.

RISK MANAGING #EMERGINGOUTFLOWS: IS THIS JANUARY 2008? - 1

Regarding point #1: EM equities (using the EEM ETF as a proxy) were disgustingly oversold at the start of the week and have bounced valiantly during the current WTD relief rally. It’s interesting to note that the EEM recorded a “nice” dead-cat bounce at the end of JAN ’08 too…

RISK MANAGING #EMERGINGOUTFLOWS: IS THIS JANUARY 2008? - 2

PICKING THE “SLIMMEST OFFENSIVE LINEMAN”

We’re often asked by our long-only clients which emerging markets we would overweight/underweight. While our answer has been and remains “underweight all of them”, we obliged the request by initially favoring consumption-oriented economies across Asia (e.g. Philippines).

Pull up a six-week chart of the PSEi Index and you’ll know exactly how wrong that call has been. Amid broad-based capital outflows, investors have clearly been reducing their EM exposure more-or-less indiscriminately.

Analyzing our Hedgeye Macro EM Equity Market Factor Model, which contains all 21 of the countries in the MSCI EM Index (plus Argentina, for good measure), we see that low-yielding, slow-growth countries that probably had relatively tighter monetary policy (at the margin) over the trailing 18-24 months (hence the low CPI and high LTM FX performance) are precisely the markets that are outperforming on a 1M basis.

RISK MANAGING #EMERGINGOUTFLOWS: IS THIS JANUARY 2008? - 3

Low-yielding, slow-growth countries with relatively tight monetary policy hasn’t exactly been the “flavor of the moth” for equity investors – particularly not in the context of why people choose to invest in emerging markets in the first place. Thus, we can reasonably conclude that the countries with the worst fundamental stories are actually the ones performing the best of late.

And when you consider that Malaysia, Mexico, Hungary, Taiwan and Morocco are actually leading the charge on a 1M basis (in USD terms), you can see exactly what we mean. We don’t have a call on Hungary or Morocco specifically, but I do cover the other three countries closely and each of them has had their fair share of fundamental headwinds of late:

  • Malaysia: political consternation surrounding the recent election rounded out by a trip to Quad #3 (i.e. Growth Slowing as Inflation Accelerates) on our GIP chart;
  • Mexico: political consternation weighing heavily upon a once-proud economic reform agenda; and
  • Taiwan: just pull up a chart of China or AAPL, given Taiwan’s economic sensitivity to China’s economic slowdown and banking woes or given tech’s weighting in the TAIEX Index.

RISK MANAGING #EMERGINGOUTFLOWS: IS THIS JANUARY 2008? - 4

What’s not working? Basically everything. What’s underperforming? Countries that have recently unearthed new economic financial market headwinds due to social unrest, banking woes or commodity deflation. If you’ll recall our industry-leading work on EM Crises, that’s essentially Pillars #4, #3 and #1 in action.

Lastly, it’s important to bear in mind that in times of crisis, investors generally sell what they can – not necessarily what they should.

WHERE TO FROM HERE?

The time will come to aggressively fade the current relief rally/dead-cat bounce(s) across EM asset classes.

In our most recent globally-interconnected macroeconomic scenario analysis, our #EmergingOutflows theme should continue trending relatively unabated in three of the four most probable outcomes with respect to the TREND duration (NOTE: not all probabilities are the same):

  1. The Chinese economy continues to suffer from structural financial sector headwinds: that would be a clear headwind to EM investor sentiment and EM economic growth;
  2. US economic growth markedly accelerates: that would keep our US monetary renormalization theme (i.e. #StrongDollar and #RisingRates) firmly intact, which has historically been the death-knell for EM asset classes;
  3. The 2013 bears get what they’ve been calling for the entire way up and the US economy finally implodes: That would be a headwind to global risk taking sentiment and liquidity. In that scenario, we’d likely see broad-based asset price deflation and a demonstrably stronger USD on a flight-to-perceived quality in the US Treasury market.
  4. Just about the only scenario where we see EM assets meaningfully rebounding from here is a TREND-duration inflection in US growth expectations that brings about an explicit promise of more QE from the Fed. Quantitatively speaking, neither the US Dollar Index, US Treasuries nor Gold view that scenario as a probable outcome at the current juncture, but we will change as the facts do.

RISK MANAGING #EMERGINGOUTFLOWS: IS THIS JANUARY 2008? - 5

 

RISK MANAGING #EMERGINGOUTFLOWS: IS THIS JANUARY 2008? - 6

 

RISK MANAGING #EMERGINGOUTFLOWS: IS THIS JANUARY 2008? - 7

For now, we remain the bulls on the USD and the bears on Gold. We also hold the axe on emerging markets and are inclined to keep chopping away on the short side. Specifically, there’s +2.9% upside to the EEM’s immediate-term TRADE line of resistance and +8.8% upside to the TREND line from last price. Barring scenario #4 as laid out above, we would short EM equities with impunity if they were to bounce all the way up to the latter of the two resistance levels.

Have a fantastic weekend,

Darius Dale

Senior Analyst