Emerging Markets: Were You Prepared?

Takeaway: We remain broadly bearish on EM assets and continue to think that absolute returns for EM assets will be negative over the intermediate term

Editor's note: This complimentary, unlocked research note was originally published January 27, 2014 at 13:23 in Macro. For more information on how you can subscribe to Hedgeye click here.

Emerging Markets: Were You Prepared? - bull9

CONCLUSIONS:

  1. We continue to think it’s of utmost importance for investors to proactively prepare their portfolios for what we continue to see as the next cycle of emerging market crises.
  2. We remain broadly bearish on EM assets and continue to see them for what they are: overpriced relative to a long-term TAIL investment cycle that has clearly turned in favor of DM assets, at the margins. For some long ideas in the DM space, look no further than our #EuroBulls theme, which continues to augur well for appreciation across the UK and German capital and currency markets.
  3. We continue to think that absolute returns for EM assets will be negative over the intermediate term. In fact, we continue to believe that EM assets lose in two out of the three most probable intermediate-term global macro scenarios. As such, we don’t think discretion is overly warranted until investors drill down into the country level.
  4. Here are three more important things to highlight: 1) the US Dollar Index remains broken TREND and TAIL (old news); 2) the 10Y Treasury Yield is now below its TREND line (new news); and 3) the CRB Index is now trading above its TREND line (new news). If this setup continues to manifest in the face of declining risk aversion, then we could get behind EM assets on the long side for trade.
  5. For now, however, we’re comfortable with our current positioning. The SPX is now testing its TREND line of support (1779); a confirmed breakdown below that level in conjunction with the VIX remaining above its TREND line does not augur well for declining risk aversion with respect to the intermediate term.

 

Needless to say, last week was a brutal week if you were running a EM FX carry-trading strategy(ies) or, if you’ve been conditioned by the past ~10Y to be permanently bullish on emerging market assets.

 

As of Friday’s close, the JPM EM Currency Index had fallen -1.8% WoW; LatAm – which remains our favorite region on the short side of EM capital and currency markets – led decliners with the Bloomberg/JPM LatAm Currency Index falling -3.2% WoW. The iShares MSCI Emerging Markets Index ETF (EEM) declined nearly -4% last week and is now down -8.5% for the YTD.

 

Emerging Markets: Were You Prepared? - dale1

*As of Friday's close.

 

Emerging Markets: Were You Prepared? - FX

*As of Friday's close.


The Argentine peso was undoubtedly the life of the party, declining over -15% last week. If you missed our note from last Thursday titled: “ARGENTINE DEFAULT 2.0?”, we encourage you to review it whenever you have a few minutes to spare; it’s a must-read for any investor attempting to understand the myriad of idiosyncratic risks that one must consider when allocating capital to emerging markets at this stage in the cycle.

 

We continue to think it’s of utmost importance for investors to proactively prepare their portfolios for what we continue to see as the next cycle of emerging market crises. Contrast the following preparation below with the hyperbolic and emotional research that you’ve likely been spammed with from the sell-side over the past ~72 hours:

 

 

All told, we remain broadly bearish on EM assets and continue to see them for what they are: overpriced relative to a long-term TAIL investment cycle that has clearly turned in favor of DM assets, at the margins. For some long ideas in the DM space, look no further than our #EuroBulls theme, which continues to augur well for appreciation across the UK and German capital and currency markets.

 

When we last left off, we had a number of ways to play this view within the construct of EM assets; below is a review of that strategy:

 

Emerging Markets: Were You Prepared? - OW LONGS

 

Emerging Markets: Were You Prepared? - UW SHORTS

 

  • ASSET CLASS LEVEL: a cumulative -117bps of equal-weighted performance
    • Overweight EEM: -6.5%
    • Underweight EMLC: -5.4%
  • REGIONAL LEVEL: a cumulative +18bps of equal-weighted performance
    • Overweight GUR: -7.5%
    • Underweight GML: -7.7%
  • COUNTRY LEVEL: a cumulative +614bps of equal-weighted performance
    • Overweight EWW: -8.6%
    • Overweight EPOL: -3.6%
    • Overweight RSX: -9.5%
    • Overweight EWY: -6.6%
    • Overweight EWT: -2.4%
    • Underweight EWZ: -8.6%
    • Underweight ECH: -7.4%
    • Underweight EIDO: +1.2%
    • Underweight THD: -5.9%
    • Underweight TUR: -14.7%

 

Obviously if we were running a fund, we would not have these positions on in equal weights; we’ve obviously been the loudest EM bears on the street since last APR, so it would only make sense to size the shorts appropriately larger than the longs.

 

From here, we continue to think that absolute returns for EM assets will be negative over the intermediate term. In fact, we continue to believe that EM assets lose in two out of the three most probable intermediate-term global macro scenarios. As such, we don’t think discretion is overly warranted until investors drill down into the country level.

 

Emerging Markets: Were You Prepared? - Global Macro Scenarios

 

In that vein, the only change we would make there would be to remove Russia (RSX) and Mexico (EWW) from the overweight ideas. Crude oil is now bearish TREND and TAIL on our quant factoring and we no longer wish to seek out that exposure on the long side. Indonesia (EIDO) is nowhere near as compelling on the short side as it once was, given the recent acceleration in hawkish rhetoric out of Bank Indonesia; still, we’d like to see them put their money where their mouth is in that regard (i.e. hike rates again) before we can get behind a turnaround story here.

 

Emerging Markets: Were You Prepared? - Crude Oil

 

Here are three more important things to highlight: 1) the US Dollar Index remains broken TREND and TAIL (old news); 2) the 10Y Treasury Yield is now below its TREND line (new news); and 3) the CRB Index is now trading above its TREND line (new news). If this setup continues to manifest in the face of declining risk aversion, then we could get behind EM assets on the long side for trade.

 

Emerging Markets: Were You Prepared? - DXY

 

Emerging Markets: Were You Prepared? - 10Y UST Yield

 

Emerging Markets: Were You Prepared? - CRB Index

 

For now, however, we’re comfortable with our current positioning. The SPX is now testing its TREND line of support (1779); a confirmed breakdown below that level in conjunction with the VIX remaining above its TREND line does not augur well for declining risk aversion with respect to the intermediate term.

 

Emerging Markets: Were You Prepared? - SPX

 

Emerging Markets: Were You Prepared? - VIX

 

For more details about our multi-factor, multi-duration quantitative overlay, please refer to slide #5 of our 1Q14 Macro Themes presentation. It remains unclear to us how so many strategists make calls on markets without a proven process to contextualize critical inflection points in global markets in real-time, but to each his/her own.

 

At any rate, we’ll stick with our process for marrying bottom-up macro fundamentals (e.g. our proprietary EM Crisis Risk Index and our deep-dive research on the previous two EM crisis cycles) with a top-down overlay (e.g. our quantitative market timing signals).

 

Don’t fix it if it ain’t broken!

 

DD

 

Darius Dale

Associate: Macro Team


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