On September 8th, we published a note titled: “SHOULD YOU REMAIN OVERWEIGHT EMERGING MARKETS?”; the conclusion of that note was as follows:
“We expect EM assets to continue outperforming their DM counterparts over the intermediate term.”
Our call which effectively bottom-ticked EM assets back in 1Q14 notwithstanding, this most recent assertion was obviously the wrong call to make from that particular time and price. In the note below, we walk through precisely why we are no longer bullish on EM assets.
Quant Signals: EM Equities Are Now Broken
The rapid decline in the prices of EM financial assets over the past couple of weeks has been broad based across both countries and asset classes. In light of that, our Tactical Asset Class Rotation Model (TACRM) is now generating a “high-conviction SELL” signal for EM Equities – the first of its kind since the week ended February 28th. For specific details on how this signal may impact your performance, please refer to today’s installment of the Macro Playbook, our daily one-page summary of core ETF recommendations, investment themes and noteworthy quantitative signals.
Moreover, the Vanguard FTSE Emerging Markets ETF (VWO) has fallen -6.3% in nearly a straight line from its September 8th closing price of $45.95 and is now broken from our intermediate-term TREND perspective:
GIP Process: Quad #4 in the US Is Bad for Emerging Markets
Obviously we don’t just anchor on quant signals to make investment recommendations; rather, we rely on a dynamic combination of top-down market analysis and bottom-up fundamental analysis when generating investment ideas and themes. Additionally, our conviction in any call is always greatest when those factors are working in unison as they are now to the bearish side of the ledger for emerging markets.
The key fundamental factor that portends a dour outlook for EM asset prices is an increasingly probable, multi-quarter trip to Quad #4 for the US economy:
Simply put, Quad #4 means that the rate of change in both real GDP growth and inflation are decelerating (i.e. the 2nd derivative is negative) and, of the four quadrants (i.e. economic scenarios) in our GIP model, Quad #4 tends to be the most unfavorable for the prices of financial assets – including EM equities and currencies:
The defensive nature of Quad #4 makes sense to us, given that the confluence of both growth and inflation slowing roughly equates to a macro headwind for any asset with either supply & demand dynamics or a cash flow profile that’s a function of the economic cycle.
Our Conviction In A Domestic Quad #4 Setup Is High And Rising
So why is the US likely to remain in Quad #4 for the time being? Regarding the slowdown in domestic economic growth specifically, the following three notes highlight our latest deep-dive thoughts on this topic:
- ARE YOU POSITIONED DEFENSIVELY ENOUGH FOR QUAD #4? (9/17)
- HOUSING: SOFT STARTS CONTINUE TO DIVERGE FROM STRONG SENTIMENT (9/18)
- HOUSING: SALES FALL AS INVESTOR INTEREST RETREATS (9/22)
Inflation is a more difficult time series to forecast at the current moment.
On one hand, 4Q14 presents us with the easiest CPI compare we’ve seen since 4Q11 on an absolute basis and the easiest CPI compare we’ve seen since 3Q10 on a relative (i.e. z-score) basis:
On the other hand, reported inflation actually decelerated in each of the aforementioned periods due to marginal USD strength (DXY up +2.1% QoQ and +6.1% QoQ, respectively), which dramatically reduced the inflationary impact of YoY commodity price appreciation in both periods. As the following charts show, that phenomenon is occurring once again and perpetuating a nascent trend of negative sequential momentum in reported inflation:
All told, as right as we ultimately were on our highly controversial #InflationAccelerating theme from the start of the year, we think our early-August call for reported inflation to decelerate from its mid-summer highs will continue to prove equally as prescient.
In the meantime, continue to ignore calls from the Consensus Macro community that wages are the primary driver of inflation; wage growth has literally done nothing since the recovery began back in mid-2009. On a highly subjective government calculation that can only really go from +1% YoY to +4% YoY (barring the financial crisis), it’s all about identifying what’s occurring on the margin within that band of probable outcomes. And what’s occurring on the margin now is decidedly disinflationary.
This continues to support our long-held assertion that: “If you get the US dollar right, you’ll get a lot of other things right in macro”.
Investment Conclusions: Sell Sell/Short/Underweight EM Equities
As you are likely well aware, we had been trumpeting a number of long ideas in the EM space in recent months and quarters. As of today, however, we are effectively removing these ideas from our active ETF recommendations. In the bullets below, we walk through our risk management thoughts around these positions:
- Sell India (EPI); Look To Buy It Back Lower: We still really like India long-term from a long-term TAIL perspective, but we are happy to risk not participating in further upside for the ability to reallocate capital at lower prices. We are not paid to willfully ignore macro risks. India is a current account deficit economy that requires a steady stream of capital inflows to sustain its economic growth and financial asset prices. Over the time frame that we’ve been actively recommending the EPI ETF on the long side, it has gained +22%, which has bested the MSCI All Country World Index’s +4.8% advance by 1724bps.
- Sell “Old China” (FXI); Look To Short It On the Bounce(s): We no longer like China here. As long as EM Equity beta is set to remain negative for a sustained period, we think investor sentiment around policy fine-tuning and the Shanghai/Hong Kong exchange linkage that has effectively buoyed Chinese equities in the face of deteriorating economic growth is set to wane. Over the time frame that we’ve been actively recommending the FXI ETF on the long side, it has dropped -2.6%, which has trailed the MSCI All Country World Index’s -2.2% decline by -36bps.
- Indonesia (EIDO); Look To Buy It Back Lower: We like Indonesia from a long-term TAIL perspective as well, but, like India, Indonesia is a current account deficit economy that requires a steady stream of capital inflows to sustain its economic growth and financial asset prices. Over the time frame that we’ve been actively recommending the EIDO ETF on the long side, it has gained +20.5%, which has bested the MSCI All Country World Index’s +7.8 % advance by 1270bps.
- Sell EM USD Debt (EMB): Tons of spread risk throughout the investment grade universe, as most recently highlighted by BlackRock’s latest commentary regarding the state of bond market liquidity: http://www.bloomberg.com/news/2014-09-22/blackrock-urges-changes-in-broken-market-for-corporate-bonds.html. Over the time frame that we’ve been actively recommending the EMB ETF on the long side, it has gained +3.1%, which has bested the iShares Barclays Aggregate Bond Index’s +0.9% advance by 220bps.
- Sell/Short A Broad EM Equity Index (VWO): Both Keith’s quant model and TACRM say, “SELL”, so we sell. In fact, we are now comfortable recommending this ETF on the short side. The best shorts are almost always former long ideas, but many investors find it difficult to make the switch with any conviction. Over the time frame that we’ve been actively recommending the VWO ETF on the long side, it has dropped -6.3%, which has trailed the MSCI All Country World Index’s -1.3% decline by -498bps. To our credit, however, we were merely swapping out EEM for VWO due to the former’s overallocation to Korean equities; the EEM ETF gained +13.6% over the time frame we were actively recommending it on the long side, which bested the MSCI All Country World Index’s +5.8% advance by 775bps. Net-net, we’re looking at a net +7.2% gain that would’ve produced a net +278bps of alpha for investors. Not terrible…
We’ll be back in the coming weeks with more country-specific EM short ideas as well. At first glance, both China and Brazil jump off the top of our heads as obvious places to begin the search.
Best of luck out there,
Associate: Macro Team