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Takeaway: Today we contextualize the relief rally in emerging market asset prices and discuss what would cause us to abandon our bearish thesis.

THEMATIC INVESTMENT CONCLUSIONS

Long Ideas/Overweight Recommendations

  1. iShares U.S. Home Construction ETF (ITB)
  2. Consumer Staples Select Sector SPDR Fund (XLP)
  3. Health Care Select Sector SPDR Fund (XLV)
  4. iShares 20+ Year Treasury Bond ETF (TLT)
  5. PowerShares DB U.S. Dollar Index Bullish Fund (UUP)
  1. LONG BENCH: Vanguard REIT ETF (VNQ), Utilities Select Sector SPDR Fund (XLU), Vanguard Extended Duration Treasury ETF (EDV)

Short Ideas/Underweight Recommendations

  1. iShares TIPS Bond ETF (TIP)
  2. iShares MSCI Emerging Markets ETF (EEM)
  3. Industrial Select Sector SPDR Fund (XLI)
  4. SPDR Barclays High Yield Bond ETF (JNK)
  5. CurrencyShares Japanese Yen Trust (FXY)
  1. SHORT BENCH: SPDR Oil & Gas Exploration & Production ETF (XOP), CurrencyShares Euro Trust (FXE), WisdomTree Emerging Currency Fund (CEW)

QUANT SIGNALS & RESEARCH CONTEXT

We’ve Been Wrong on Emerging Markets For ~6 Weeks… Why?: On 12/16, we hosted a conference call titled, “#EmergingOutflows Round II: This Time Is Actually Different” to reiterate and expand upon our bearish bias on emerging market asset prices and economies.

Since the aforementioned call, EM asset prices have actually gone up; in fact, 12/16 marked the low in many EM capital and currency markets amid the height of the Russian ruble crisis. On the call, we introduced 10 new EM ETF short ideas (EEM, EMB, EMLC, EMCB, CEW, GML, EWZ, ICOL, NGE and RSX); on average, those 10 ETFs have moved -368bps against the direction of our thesis. Not our best work; far from it, actually.

Not to beat ourselves up, however, the two long ideas we introduced on the call (EPHE and TUR) are performing as well as any asset class in all of Global Macro over that time frame and have moved +784bps and +1,520bps, respectively, in the direction of our thesis.

THE HEDGEYE MACRO PLAYBOOK - EM Idea Flow Monitor

Since we switched from being bullish to being bearish on emerging markets in our 9/23 note titled, “EMERGING MARKETS: THE EM RELIEF RALLY IS LIKELY OVER”, the MSCI EM Index has fallen -4.3%, the JPM EM Currency Index has fallen -9.0% and the Bloomberg USD EM Composite Bond Index has fallen -1.2%. Those returns compare to a gain of +3.8% for the S&P 500 Index, a gain of +11.9% for the U.S. Dollar Index and a gain of +4.5% for the Bloomberg U.S. Treasury Bond Index.

Clearly being bearish on emerging markets over the past ~4 months was the right call to make.

But is being bearish on emerging markets the right call going forward?

Specifically, are the factors which are driving the current relief rally across EM capital and currency markets likely to remain in place for the foreseeable future?

In order to answer that question, we have to first figure out what’s been driving the relief rally in the first place. Rather than use conjecture and/or assumptions, we’ve deferred to math in the following chart:

THE HEDGEYE MACRO PLAYBOOK - CUSTOM PERIOD MDCS

What you’ll quickly note (likely thanks to our highlighting of key, non-intuitive correlations) is that it’s more than reasonable to attribute the relief rally to the recovery in European financial assets in expectation for and reaction to the ECB’s recent QE announcement due to the tight positive correlations with European equities.

Additionally, one can also conclude that the sharp rally in European fixed income has left European investors yieldless, at the margins, and has perpetuated a massive yield chase across global financial markets which has benefitted EM assets, which are typically higher yielding than their DM counterparts. Yes, this is the same yield chase we’ve seen benefit U.S. Treasury bonds over the past 6-9 months. We can deduce this by noting the tight positive correlations to DM high-dividend stocks, global REITs, USD-denominated and EUR-denominated high-yield debt, as well as the U.S. dollar itself – that latter of which has historically been inversely correlated to EM asset prices.

THE HEDGEYE MACRO PLAYBOOK - 1 27 2015 7 26 05 AM

Source: Bloomberg L.P.

Will the rally in European equities and the ECB-induced global yield chase last? Of course we can’t know the answer to either question on an ex ante basis, but what we do know is that the higher the U.S. dollar climbs, the more risk there is to the downside in EM asset prices and economic growth.

THE HEDGEYE MACRO PLAYBOOK - EM   The Great Unwind

THE HEDGEYE MACRO PLAYBOOK - EM   Carry Trade

THE HEDGEYE MACRO PLAYBOOK - EM   GDP

THE HEDGEYE MACRO PLAYBOOK - EM   Foreign Non Official Holdings of Govt Debt

THE HEDGEYE MACRO PLAYBOOK - EM   Change in Foreign Non Official Holdings of Govt Debt

More importantly, our quantitative signals continue to support maintaining a bearish bias on EM asset prices. Specifically, our Tactical Asset Class Rotation Model (TACRM) continues to generate a “DECREASE Exposure” signal for EM Equities as a primary asset class.

THE HEDGEYE MACRO PLAYBOOK - TACRM EM Equities Backtest

That being said, however, any persistent strength in the breadth of this asset class is likely to perpetuate a bullish signal in the coming weeks/months. Moreover, that would likely coincide with a bearish-to-bullish TREND reversal on Keith’s quant signals as well. Either event would cause us to remove our bearish fundamental thesis on this asset class.

THE HEDGEYE MACRO PLAYBOOK - TACRM GMRS

***CLICK HERE to download the full TACRM presentation.***

TRACKING OUR ACTIVE MACRO THEMES

Global #Deflation: Amidst a backdrop of secular stagnation across developed economies, we continue to think cyclical forces (namely #StrongDollar driven commodity price deflation) will drag down reported inflation readings globally over the intermediate term. That is likely to weigh heavily upon long-term interest rates in the developed world, underpinning our bullish outlook for U.S. Treasury bonds.

Draghi Delivers the Drugs! (1/22)

#Quad414: After DEC and Q4 (2014) data slows, in Q1 of 2015 we think growth in the US is likely to accelerate from 4Q, aided by base effects and a broad-based pickup in real discretionary income. We do not, however, think such a pickup is sustainable, as we foresee another #Quad4 setup for the 2nd quarter. Risk managing these turns at the sector and style factor level will be the key to generating alpha in the U.S. equity market in 1H15.

The Hedgeye Macro Playbook (1/23)

Long #Housing?: The collective impact of rising rates, severe weather, waning investor interest, decelerating HPI, and tighter credit capsized housing in 2014.  2015 is setting up as the obverse with demand improving, the credit box opening and 2nd derivative price and volume trends beginning to inflect positively against progressively easier comps. We'll review the current dynamics and discuss whether the stage is set for a transition from under to outperformance for the complex.

EHS | RoC Solid (1/23)

Best of luck out there,

DD

Darius Dale

Associate: Macro Team

About the Hedgeye Macro Playbook

The Hedgeye Macro Playbook aspires to present investors with the robust quantitative signals, well-researched investment themes and actionable ETF recommendations required to dynamically allocate assets and front-run regime changes across global financial markets. The securities highlighted above represent our top ten investment recommendations based on our active macro themes, which themselves stem from our proprietary four-quadrant Growth/Inflation/Policy (GIP) framework. The securities are ranked according to our calculus of the immediate-term risk/reward of going long or short at the prior closing price, which itself is based on our proprietary analysis of price, volume and volatility trends. Effectively, it is a dynamic ranking of the order in which we’d buy or sell the securities today – keeping in mind that we have equal conviction in each security from an intermediate-term absolute return perspective.