Takeaway: Consistent with recent quantitative developments and our fundamental GIP process, we now think the risk is to the downside for EM Equities.
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:
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:
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
Takeaway: After sending the "Reduce EM Exposure" message via the “MACRO PLAYBOOK,” fundamental headwinds pressuring copper prices have a catalyst.
Earlier today, we sent out the EM sell signals in our MACRO PLAYBOOK one pager with the following conclusions:
With regards to our copper position, the bearish fundamental thesis now has a catalyst:
Copper has gone through a BULLISH TO BEARISH TREND REVERSAL, and the fundamental supply/demand outlook over the longer-term supports the short copper thesis.
While a slowdown in the commodity fueled credit financing bubble in China and the expectation for a steady increase in global supply coming onto the market over the next two years have suggested lower prices for quite some time now, a 1) A BULLISH Quant set-up in Chinese equities fueled by the positive effects of monetary stimulus at the regional and local government level from Beijing; AND 2) a BULLISH quant set-up in copper, likely fueled by the Chinese catalyst (SEE BELOW), helped to support prices over the summer.
BOTH OF THESE TRENDS HAVE NOW REVERSED:
With market activity working with the downside price move to confirm the bearish set-up, market activity and current sentiment suggest perception of the next catalyst has the ability to induce outsized moves in either direction.
Data showing the net positions from money managers reveals open interest is at a 7-week high:
The market as a whole is shorter as evidenced by the commitments of traders reports released Friday by the CFTC, but the speculative positions by large money managers is increasing. At the same time, volatility is being sold for less than its trailing averages. When this occurs, the probability increases for price movements that test critical capitulation levels compresses. The expectation for less volatility with larger, speculative size behind a market is the perfect set-up for more volatility on a catalyst.
While copper is down -10% on the year, we believe a cyclical downtrend has much farther to run over the next few years.
Please see the links below for two previous notes outlining the fundamental headwinds that will continue pressuring copper prices over the intermediate to long-term. We’ll follow-up with additional data supporting the call in the coming weeks. At the time of publication of these two notes, copper was in a BULLISH TREND set-up making the fundamental picture look obsolete.
The first note outlines China’s share of global base metals demand and proceeds to outline how the expectation for over-extended demand growth looks unsustainable from here.
Highlights from the Note:
- Nickel: 47.4%
- Aluminum: 46.1%
- Zinc: 45.6%
- Copper: 42.4%
In the following update at the end of August, copper was on the verge of breaking down. We highlighted Jakarta’s reversal to its copper bauxite export ban put in place in January. While Indonesia isn’t near the top of copper producing countries, China’s move to diversify supply lines elsewhere, and Indonesia’s mid-year lift on the ban will add to what we see as an excess amount of supply coming on over the next few years.
The following quote from the note highlights our conclusions:
“We will be watching the following factors in the coming weeks for a read-through on the supply outlook:
1) Chinese economic outlook takes a more definitive turn positive or negative
2) The Indonesian copper bauxite export picture reaches a long-term resolution
3) Continued confirmation in a late-cycle mining cap-ex push from the largest miners
4) A continued positive Trend for the USD
With these fundamental factors in play, copper may be interesting on the short-side if our @Hedgeye $3.16 TREND line breaks and confirms.”
This TREND Line of support did in fact break, and to re-iterate, copper is now BEARISH from an intermediate-term TREND perspective with $3.16 now a RESISTANCE level. With the quant now agreeing with the fundamental picture, we will look to short copper on the oversold risk management signals.
Please reach out with any comments or questions.
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Takeaway: Good 3Q beat but the focus is now on 2015 costs and whether Europe momentum can be sustained.
Given trends seen from our pricing survey, we believed a F3Q beat was already in the bag with the Caribbean, while slowly improving, still limping along in a tough promotional environment. The ECA cost impact may be a little above expectations but more importantly, we wonder if the exuberance on Europe is overstated heading into 2015.
Q & A
In this excerpt from today's Morning Macro Call, Hedgeye CEO Keith McCullough discusses the recent trend we’ve been highlighting of down moves in U.S. stocks on greater-than-usual volume, and why investors need to be particularly careful right now with respect to the bubble in small cap stocks.
Hosted by Hedgeye CEO Keith McCullough at 9:00am ET, this special online broadcast offers smart investors and traders of all stripes the sharpest insights and clearest market analysis available on Wall Street.