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    MARKET EDGES

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Takeaway: EM debt and EM FX should continue to broadly decline while EM equity returns should become increasingly bifurcated at the country level.

SUMMARY BULLETS:

  1. We remain bearish on emerging market debt (both USD and local currency paper) and emerging market currencies with respect to the intermediate-term TREND and long-term TAIL. Irrespective of idiosyncratic country fundamentals, we think #StrongDollar, #RatesRising and #DebtDeflation will be hard for any emerging market to overcome in this environment. There will, of course, be relative winners and losers, but we think you can continue to extract absolute returns with a passive strategy.
  2. On the LONG side of EM equities from here (TREND and TAIL duration), we like South Korea, Poland, Thailand and Mexico. While absent from our EM Crisis Risk Index due to the lack of cross-country comparable data, Taiwan also looks solid fundamentally (stable currency, great BOP dynamics, mature and liquid financial markets…).
  3. On the SHORT side of EM equities from here (TREND and TAIL duration), we like South Africa, Nigeria and Indonesia. We’re also inclined to loop India and Brazil back into this mix, but they’re so bombed-out on longer-term durations (i.e. 1Y, 18M and 3Y), one has to start to wonder how much more downside is left.

When EM capital and currency markets were appropriately tanking into their late-JUN lows, making money on the short side of the emerging markets space was so easy even a bunch of former football and hockey players could do it. While never in search or need of validation for our research conclusions, we’d be lying if we said it wasn’t gratifying to see world-class investors such as Ray Dailio adopt what is essentially our #EmergingOutflows thesis.

As highlighted by our EM divergence monitor (full methodology below), just about any asset that had been previously perma-bull marketed to investors as an “emerging market” was down double digits on a trailing 1M, 3M and 6M basis at the JUN 24 low in the MSCI Emerging Market Index.

(prices and performance figures as of 6/24)

REFRESHING THE #EMERGINGOUTFLOWS PLAYBOOK - 1

Flash forward to today, we’re seeing some pretty solid dead-cat bounces uniformly across the EM space on a WoW basis; in fact, the only primary or secondary asset class that isn’t up is Peruvian equities (down -0.1% WoW). Looking to performance across the 1-3 month time frame tells a different tale, however, in that the performance is decidedly less uniform.

REFRESHING THE #EMERGINGOUTFLOWS PLAYBOOK - 2

In line with this market signal, we think it will become increasingly important for equity investors to become “country-pickers”.

It’s worth stressing that by “country-pickers”, we are not referring to the traditional “ABC country has great demographics and will be XYZ percent of global GDP by 2030” perma-bull marketing that is found in every emerging market fund prospectus on the planet.

Conversely, in a #StrongDollar, #RisingRates environment, we think the direction, supply and cost of global capital flows will increasingly determine the trend rates of growth, inflation, urbanization and reformation across the emerging market space – just as the USD and US interest rates did on the way down.

Specifically, we believe it to be flat-out intellectually dishonest to suggest that a pervasively weak dollar and cheap, excessive global capital haven’t perpetuated a golden era in EM economic and financial market conditions during the most recent EM “boom” cycle as it had done in the two previous cycles (late-70s to the early-80s and late-80s to the mid-90s).

Simply put, the absolute return strategy of gathering assets and aggressively “diversifying” into emerging markets is over and, quite frankly, it’s been over for a while now (FYI, EM equities peaked when the USD bottomed in 2011 – alongside other consensus carry trading strategies such as gold, commodities and EM currencies).

REFRESHING THE #EMERGINGOUTFLOWS PLAYBOOK - ASSET ALLOCATION SHIFT

 

REFRESHING THE #EMERGINGOUTFLOWS PLAYBOOK - CORRELATIONS

In light of this updated view, we thought it would be helpful to rehash where we think intermediate-to-long-term investors will be most rewarded for investing their hard-earned capital on the long and short side of emerging markets:

  • We remain bearish on emerging market debt (both USD and local currency paper) and emerging market currencies with respect to the intermediate-term TREND and long-term TAIL. Irrespective of idiosyncratic country fundamentals, we think #StrongDollar, #RatesRising and #DebtDeflation will be hard for any emerging market to overcome in this environment. There will, of course, be relative winners and losers, but we think you can continue to extract absolute returns with a passive strategy.
  • On the LONG side of EM equities from here (TREND and TAIL duration), we like South Korea, Poland, Thailand and Mexico. While absent from our EM Crisis Risk Index due to the lack of cross-country comparable data, Taiwan also looks solid fundamentally (stable currency, great BOP dynamics, mature and liquid financial markets…).
  • On the SHORT side of EM equities from here (TREND and TAIL duration), we like South Africa, Nigeria and Indonesia. We’re also inclined to loop India and Brazil back into this mix, but they’re so bombed-out on longer-term durations (i.e. 1Y, 18M and 3Y), one has to start to wonder how much more downside is left.

REFRESHING THE #EMERGINGOUTFLOWS PLAYBOOK - EMB

 

REFRESHING THE #EMERGINGOUTFLOWS PLAYBOOK - EMLC

 

REFRESHING THE #EMERGINGOUTFLOWS PLAYBOOK - CEW

Below, we present our latest Hedgeye Macro Emerging Market Crisis Risk Index as some support for these selections. You’ll note that we didn’t just pick the absolute best vs. the absolute worst; other factors (such as accessibility and quantitative signals contributed to our thought process):

REFRESHING THE #EMERGINGOUTFLOWS PLAYBOOK - EXPLANATION TABLE

 

REFRESHING THE #EMERGINGOUTFLOWS PLAYBOOK - PILLAR I

 

REFRESHING THE #EMERGINGOUTFLOWS PLAYBOOK - PILLAR II

 

REFRESHING THE #EMERGINGOUTFLOWS PLAYBOOK - PILLAR III

 

REFRESHING THE #EMERGINGOUTFLOWS PLAYBOOK - PILLAR IV

 

REFRESHING THE #EMERGINGOUTFLOWS PLAYBOOK - AGGREGATED RISK

 

REFRESHING THE #EMERGINGOUTFLOWS PLAYBOOK - SUMMARY TABLE

Please email us any time you’d like to receive our more nuanced thoughts on a specific country and/or its capital and currency markets. We’ve done all the analytical heavy-lifting and we continue to monitor for critical deltas and inflection points each day so it’s no trouble at all for us to assist you in that regard.

Have a great evening,

Darius Dale

Senior Analyst

NOTES ON THE HEDGEYE MACRO EMERGING MARKET DIVERGENCE MONITOR:

To help clients get a better grasp of all the moving parts across EM capital and currency markets, we have created a dashboard to systematically monitor performance divergences with the intent on flagging developing, existing, and dissipating trends in the marketplace. The dashboard is specifically programmed to highlight divergences in EM primary and secondary asset classes that are in excess of [1] standard deviation relative to their respective sample means.

The dashboard is grouped into three distinct buckets (i.e. samples): Asset Classes, Regions and Countries. Realizing that we could and should do better than implementing an all-or-nothing strategy in emerging markets, this multi-tiered setup will allow us to spot the development and dissipation of said trends at the level most appropriate for any given investor.

Lastly, we thought it would be best to use actual ETFs, rather than the benchmark indices themselves to track said divergences because: A) the universe of liquid ETFs most likely accurately reflects the universe of broadly investable emerging market securities and asset classes; B) the ETFs are all both un-hedged and priced in US dollars, which means they automatically adjust for deltas in the currency markets; and C) ETFs have an underlying fund flow element to them that influences price trends – which is precisely what we’re trying to capture with our #EmergingOutflows thesis.

It’s also worth noting that whenever there was a collection of ETFs that represented a particular asset class, region and/or country, we selected the specific ETF in our sample based on a combo score of size (AUM) and liquidity (average daily trading volume).