Is the EM Relief Rally Nearing Its [Eventual] End?

Takeaway: We now believe EM assets are generally priced quite richly relative to our intermediate-to-long-term fundamental outlook for the space.

Our sincerest congrats to anyone who’s nailed this low-quality relief rally across global financial markets in which nearly everything levered to reflation, excessive leverage, and/or illiquidity risk led. While we’ve been the axe on the bear side of emerging markets since early 2013, we wrongly missed getting out in front of the aforementioned short squeeze with a tactical short covering view.


With respect to EM asset class returns specifically:


  • The MSCI Emerging Markets Equity Index has gained +20.6% from its 1/21 YTD trough;
  • The JPMorgan EM FX Index has gained +7.7% from its 1/21 YTD trough;
  • The Bloomberg EM Local Currency Sovereign Debt Index has gained +5.4% from its 1/20 YTD trough; and
  • The Bloomberg EM USD Corporate Bond Index has gained +6% from its 1/20 YTD trough.


These are the kinds of wildly impressive ~two month returns you can make your year on – especially if you don’t give it all back. We do, however, see mounting risk of investors “giving it all back” over the intermediate-term. Moreover, our long-term call on EM remains ultra-bearish for a variety of reasons, most recently highlighted on our recent conference call titled, “Is This a Generational Buying Opportunity in Emerging Markets?” (3/16).


CLICK HERE to access the video replay of the call, as well as the associated 105-page slide deck in PDF format.


The three key conclusions of the call were as follows:


  1. We see further downside at the primary asset class level, as well as elevated risk of material bankruptcy cycles in a number of key emerging market economies.
  2. While we remain explicitly and overtly bearish on the Chinese economy and RMB, we believe investor consensus is far too bearish on both. Most of the analysis we’ve seen inappropriately analyzes the Chinese financial sector from the perspective of Western economies; nor does it include the full range of potential outcomes – including a secular bull market in the Chinese currency and Chinese equities.
  3. On the long/overweight side we like Emerging Europe (i.e. Poland, Hungary and Czech Republic), South Korea and Thailand. In terms of short/underweight candidates, we think Latin America (specifically Brazil, Mexico and Colombia), Indonesia and South Africa are most at risk for #PhaseIII of our #EmergingOutflows theme – i.e. a wave of bankruptcy cycles.


As we take this opportunity to pound the table on the latter risk, there remains a large compendium of investors that believe EM assets are both “cheap” and a “crowded short”. We do, however, continue to believe that valuation and sentiment are not catalysts for sustained recoveries in asset prices or economies.


Is the EM Relief Rally Nearing Its [Eventual] End? - MSCI EM Index EV to EBITDA Ratio vs. MSCI World Index


On the contrary, we view the following as likely catalysts for ongoing economic deterioration and asset price declines across the emerging market space:


  1. Intermediate-term (2-3 quarters): a cyclical recovery in the U.S. dollar; and
  2. Long-term (2-3 years): a meaningful NPL cycle across key emerging market economies.


Regarding the former risk, we think a 2nd quarter delta into #Quad4 in the U.S. followed by what is likely to be two consecutive quarters of #Quad2 in 2H16 (assuming the U.S. economy is able to avoid an outright recession) may prove fundamentally bullish for the DXY – which has been consolidating in both market price and speculative net length terms for over a year now. Recall that quadrants two and four have historically proven most positive for the USD vs. peer currencies.


Is the EM Relief Rally Nearing Its [Eventual] End? - UNITED STATES


Is the EM Relief Rally Nearing Its [Eventual] End? - U.S. Dollar Index


Is the EM Relief Rally Nearing Its [Eventual] End? - EXTREME SENTIMENT MONITOR


Regarding the latter risk, we continue to see elevated risk in any buy-and-hold strategy in EM assets ahead of what is likely to be a material bankruptcy cycle that ripples across many EMEs. Per IIF data, outstanding debt in EM economies across all sectors reached $62 trillion (or 210% of GDP) in 2015. Roughly 40% of that stockpile of debt is in the nonfinancial corporate sector – which is especially exposed to structurally depressed commodity prices (read: perpetually lower FCF absent a material and sustained recovery in commodity prices).


Is the EM Relief Rally Nearing Its [Eventual] End? - CRB Index vs. MSCI Emerging Markets Index EPS


Per our analysis, we haven’t seen anything yet in terms of a meaningful NPL cycle across emerging markets. The median and mean NPL ratios across the 20 emerging market economies covered by our proprietary EM Crisis Risk Index are 3% and 3.6%, respectively, which compares to the 1 EM bankruptcy cycle peaks of 12.4% and 14.2% – which were both recorded in 1999, respectively. Moreover, those NPL ratios are only beginning to trend higher off all-time lows as a spread to the mean and median NPL ratios across advanced economies. This would imply a substantial degree of pain is yet to come.


Is the EM Relief Rally Nearing Its [Eventual] End? - EME NPL Ratio vs. AE NPL Ratio


Is the EM Relief Rally Nearing Its [Eventual] End? - EME NPL Ratio vs. AE NPL Ratio Spread


Don’t get piggy on the long side of emerging markets. Keep a [great] trade a trade out there.




Darius Dale


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