SEPARATING THE FOREST FROM THE TREES IN EMERGING MARKETS

Takeaway: Investors should avoid staring at the “trees” in lieu of the “forest” that is the fundamental bear case for emerging markets.

SUMMARY BULLETS:

 

  • We think a protracted tightening of global credit conditions driven by sustained USD appreciation and a back-up in US interest rates will weigh on growth in EM fixed investment (via an inflection(s) in portfolio and FDI flows) and growth in EM consumption (via an inflection in purchasing power as EM FX reverts to the mean).
  • We think global asset allocators in developed markets are simply running out of places to direct marginal investment flows and growth assets priced in a strengthening USD (and potentially those priced in a burning JPY) are one of the few places that remain attractive on a go-forward basis. Thus, our #EmergingOutflows thesis (click HERE and HERE for more details) should continue to play out in spades.
  • We think the impact on China’s secular economic slowdown will weigh heavily upon EM economic growth, as China’s fixed assets investment bubble has been a primary driver of marginal demand for many/most of the larger emerging market economies. In particular, the policy-induced unwind of said bubble should sustainably slow export and FDI growth across key commodity-producing countries (click HERE and HERE for more details).
  • Various EM asset classes could bounce another +5-10% from here to their respective TREND lines of resistance without signaling any shift in our interpretation of the fundamentals.

 

It’s later than I’d like it to be on a Friday in mid-July so I’ll make this one real quick: we remain the bears on emerging market economies and asset classes.

 

From a long-term perspective, investors in EM capital and currency markets have had a great run. That is, however, precisely the problem with assets that have made investors a lot of money: it’s difficult to cut ties when the underlying fundamental drivers are no longer supportive of continued outperformance.

 

SEPARATING THE FOREST FROM THE TREES IN EMERGING MARKETS - 1

 

One of the hardest things to do in trading macro markets is spotting regime/phase changes and that’s typically when justifications like “valuation” come into play and investors start to perpetuate and chase dead-cat bounces to lower long-term highs.

 

We are firm believers that valuation is more often an excuse, not a catalyst when it comes to Global Macro trading – which itself is dominated primarily by flows that are ultimately perpetuated by economic gravity. For emerging markets specifically, the “economic gravity” is as follows:

 

  • We think a protracted tightening of global credit conditions driven by sustained USD appreciation and a back-up in US interest rates will weigh on growth in EM fixed investment (via an inflection(s) in portfolio and FDI flows) and growth in EM consumption (via an inflection in purchasing power as EM FX reverts to the mean);
  • We think global asset allocators in developed markets are simply running out of places to direct marginal investment flows and growth assets priced in a strengthening USD (and potentially those priced in a burning JPY) are one of the few places that remain attractive on a go-forward basis. Thus, our #EmergingOutflows thesis (click HERE and HERE for more details) should continue to play out in spades; and
  • We think the impact on China’s secular economic slowdown will weigh heavily upon EM economic growth, as China’s fixed assets investment bubble has been a primary driver of marginal demand for many/most of the larger emerging market economies. In particular, the policy-induced unwind of said bubble should sustainably slow export and FDI growth across key commodity-producing countries (click HERE and HERE for more details).

 

SEPARATING THE FOREST FROM THE TREES IN EMERGING MARKETS - DXY

 

SEPARATING THE FOREST FROM THE TREES IN EMERGING MARKETS - UST 10Y

 

SEPARATING THE FOREST FROM THE TREES IN EMERGING MARKETS - 4

 

After gauging the pulse of the international investment community via feedback from our 3Q13 Macro Themes call earlier this week and visiting with clients and prospects all week in London, we don’t buy into the increasingly-consensus view that “EM assets are cheap”. Even if we did, there is ample room for cheap to get cheaper over the intermediate-to-long term:

 

SEPARATING THE FOREST FROM THE TREES IN EMERGING MARKETS - 5

 

Net-net-net, all of this begs the following question: are you A) positioning your portfolio to take advantage of “attractive valuations” because “consensus it too bearish on emerging markets”; OR are you B) using any immediate-term strength in EM capital and currency markets to sell into?

 

You know where we stand on that one (i.e. option “B”). If, however, you trust your process and it leads you to option “A”, just be aware of the upside/downside risks. Various EM asset classes could bounce another +5-10% from here to their respective TREND lines of resistance without signaling any shift in our interpretation of the fundamentals. Recall that market prices generally dictate our interpretation of any set of economic variables; experience has taught us to humbly accept that us football and hockey jocks will never be smarter than Mr. Market!

 

SEPARATING THE FOREST FROM THE TREES IN EMERGING MARKETS - 6

 

SEPARATING THE FOREST FROM THE TREES IN EMERGING MARKETS - 7

 

SEPARATING THE FOREST FROM THE TREES IN EMERGING MARKETS - 8

 

SEPARATING THE FOREST FROM THE TREES IN EMERGING MARKETS - 9

 

We realize that not everyone uses or is comfortable with using a proven quantitative overlay to filter and interpret immediate-term noise within the context of intermediate-to-long-term fundamental trends. That’s fine; to each his/her own. However, this proprietary research and risk management process has kept us on the right side of most of the major market moves since starting the firm ~5 years ago and we don’t intend to abandon said process now.

 

As such, we continue to warn that investors should avoid staring at the “trees” in lieu of the “forest” that is the fundamental bear case for emerging markets.

 

Have a great weekend,

 

Darius Dale

Senior Analyst



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