- We think yesterday’s price action confirms our once-controversial view that EM asset prices are not much more than a function of a global carry trade born out of USD debasement.
- To the extent the duration of said debasement is being extended on the margin, we DO NOT think it is appropriate to aggressively wager on continued #EmergingOutflows over our immediate-term TRADE duration.
- Specifically, we need time to access whether or not our quantitative risk management levels confirm the continuation or conclusion of our #StrongDollar and #RatesRising themes.
- If a continuation is confirmed, our patience will eventually be rewarded with better entry prices on the SHORT side of EM assets. If a conclusion is confirmed, we see #EmergingOutflows as a phenomenon that will eventually play out over the long-term TAIL, rather than a TREND & TAIL duration event; in fact, a number of EM assets would actually appear attractive to us on the LONG side with respect to our intermediate-term TREND duration.
- Lastly, we update our views on how to play our #EmergingOutflows theme at the asset class and country level at the conclusion of this note. Email us if you’d like to dig deeper into a specific country or region.
Looking to our custom Emerging Markets Divergence Monitor, EM assets were up +3% yesterday, on average, at the asset class level. At the regional level, they were up +3.9% on average yesterday and, at the country level, the were up +4.1% on average. As of yesterday’s close:
If you didn’t know what the real bull case for emerging markets was, now you know: debasement of the world’s reserve currency – largely born out of domestic financial repression.
In simpler terms, EM assets are a carry trade that is financed by the cheapness and abundance of USD-denominated global capital flows. Moreover, the institutionalized reach for yield has been a boon to EM asset prices over the past ~decade.
After a day like yesterday, any investor would be hard-pressed to push back on our interpretation of the bull case for emerging markets with the same tired reasons that are marketed in mutual and exchange-traded fund prospectuses.
Such pushback is often riddled with consensus buzzwords and catchphrases like “RAPID GROWTH” and “DIVERSIFICATION” and “A LEVERED PLAY ON GLOBAL GROWTH” and [my personal favorite] “INVESTORS ARE UNDER-ALLOCATED TO COUNTRY XYZ BASED ON ITS SHARE OF GLOBAL GDP”.
In our view, none of those storytelling factors improved on the margin yesterday – at least not enough to justify yesterday’s broad-based, hog-wild appreciation across the spectrum of EM assets.
Rather, the two primary factors responsible for determining the direction and magnitude of global capital flows into emerging market economies both were indeed supportive on the margin: the US Dollar Index (a proxy for the USD) plummeted to a ~7M low of 80.24 and the UST 10Y Yield (a proxy for US interest rates) dropped -16bps DoD to 2.69%.
Perhaps more importantly, the US Dollar Index snapped our 81.34 TREND line of support:
Interestingly, the UST 10Y Yield did not. The bond market is currently experiencing what we’d argue are growth-induced outflows (roughly -3% of beginning AUM) – as opposed to being perpetuated by rising inflation expectations or accelerating credit risk.
It’s worth noting that the 5Y Breakeven Rate has fallen -10bps since the UST 10Y Yield put in its YTD trough on MAY 2 and 5Y CDS for the United States has also dropped -10bps since then. The price of gold – which gold bugs would happily consider a rough proxy for both inflation expectations and sovereign default risk – has declined -6.7% over that same time frame.
In the context of declining inflation expectations and perceived credit risk, there can be only one reason for #RatesRising: #GrowthAccelerating.
Well, as Keith highlighted in today’s Early Look, our Street-leading positive outlook for US economic growth has gotten decidedly less positive with yesterday’s central planning episode.
In light of this, we can’t sit here with a straight face and tell you to keep shorting emerging markets on the bounce(s). Indeed, as we all have witnessed during 2010-12, #WeakDollar has tended to perpetuate a reflexive cycle of #GrowthSlowing followed by more #WeakDollar.
If Bernanke wants investors to roll the bones in Indian rupee or Indonesian rupiah-denominated assets from here, then so be it. We’re certainly not wed to the concept of #EmergingOutflows at every TIME and PRICE.
That said, however, proceed with such speculation at your own risk. If the UST 10Y Yield is signaling anything to us at the current juncture, it is that the TREND in US growth – on both a reported and expectations basis – continues to accelerate.
Either that or the market is coming to the conclusion that Janet Yellen winds up being slightly more hawkish or responsive to economic fundamentals than her current boss has been – which, obviously, is not that hard to do.
At any rate, whether or not a TREND-based acceleration in domestic economic growth is sustainable from here largely depends on what happens to the purchasing power of the American consumer (i.e. 70-plus percent of US GDP) from here.
With Fed tapering on hold likely though year-end (the next FOMC decision is on OCT 30 – too soon for economic data to show enough improvement for Bernanke to justify tapering then vs. not tapering yesterday; and the following FOMC decision is on DEC 18 – they probably won’t do anything meaningful around Christmas time), the direction of fiscal policy will take center stage in determining the course of the world’s reserve currency.
Our latest thoughts on US fiscal policy can be found in yesterday’s Early Look. Stay tuned for more; we’ll be publishing a deep-dive on US fiscal policy in the coming weeks.
For now, we think it’s worth reducing your gross exposure to our #EmergingOutflows theme, to the extent you have any positions on that are attempting to express this view.
In conclusion, while we still think the structural underpinnings of #EmergingOutflows remains intact and, thus, should continue to help US-centric assets outperform EM assets over the long-term TAIL, we think the timing of that call should be appropriately delayed pending more clarity on the scope and pace of US monetary policy renormalization.
Delayed US monetary policy renormalization = #EmergingINflows for the time being (emphasis on the world, “delayed”).
Per World Bank Managing Director Sri Mulyani Indrawati: “Emerging nations should prepare for an eventual reduction in US stimulus even as the Federal Reserve unexpectedly refrained from adjusting policy this week. They have to prepare, they don’t have any other choice.”
As always, however, TIMING trumps our/anyone's interpretation of the FUNDAMENTALS (i.e. risk management > research).
NOTES ON OUR PROPRIETARY EMERGING MARKET CRISIS RISK INDEX
Using previous crises as a guidepost, we carefully indentified ten key economic indicators across four key categories (i.e. “Pillars”) to rank emerging market economies according to their risk of experiencing a crisis.
At the single indicator level, each country is ranked according to its length of standard deviations from the sample average. A higher deviation always indicates greater risk, so for indicators where a higher value is healthy (like a current account balance or fiscal balance), we inverted the signs.
Each country’s deviations are then averaged and multiplied by a constant to produce a composite score at the Pillar level. Certain indicators were given a higher weighting in the average based on both historical precedent and what we viewed as the eminent areas of risk in the current cycle.
Lastly, the aggregated risk score for any country is an arithmetic mean of its four Pillar-level scores.
On our proprietary risk metrics, we think the following setup is how investors should be allocated to EM equities over the intermediate-term TREND and long-term TAIL:
- 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 (e.g. a stable currency, great BOP dynamics and mature and liquid financial markets).
- On the SHORT side of EM equities from here (TREND and TAIL duration), we like South Africa, Nigeria, Turkey 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.
To the extent #RatesRising and #StrongDollar remain in play, 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.
NOTES ON OUR CUSTOM 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  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:
- The universe of liquid ETFs most likely accurately reflects the universe of broadly investable emerging market securities and asset classes;
- The ETFs are all both un-hedged and priced in US dollars, which means they automatically adjust for deltas in the currency markets; and
- 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).