“It does not matter how slowly you go as long as you do not stop.”
While we are all well aware of the incredibly thoughtful, oracle-esque nature of Chinese philosopher Confucius and his many proverbs, it’s a bit hair-raising to see him completely nail the current balance of Chinese economic and financial market risks some ~2,500 years after his death.
The aforementioned quote pretty much sums up how macro markets have generally priced in Chinese developments throughout much of the YTD. Specifically, one could argue that China hasn’t meant all that much to the consensus macro narrative since January. Indeed, as was the case throughout our latest rounds of client meetings, China has been conspicuously absent on both sides of the bull/bear debate.
I guess you could say that China’s ongoing structural economic deterioration doesn’t really matter as long as the yuan and/or entire mainland banking system aren’t imploding today.
Back to the Global Macro Grind…
Our call on China this year has been as boring as it has been accurate. Recall that at the height of CNY devaluation fears in January/early-February, we fervently remained the other side of the then-consensus view that China was careening towards a currency crisis and banking collapse.
From our 1/13 note titled, “Inverse Myopia: Checking In With Asia and Latin America”:
“As we’ve previously stated, the CNY needs to depreciate by as much as 10-15% vs. the USD, but any such devaluation will come at a measured pace. Beijing has no interest in AFC-style rapid devaluations and will continue to use their wide arsenal of tools – including coercion and capital controls – to achieve this objective, which effectively implies the bearish CNY overhang is here to stay. All told, we reiterate our bearish bias on Chinese capital markets and the yuan.”
From our 2/9 note titled, “Looking for Investment Ideas Across Asia, LatAm or EEMEA?”:
“[Chinese] officials continue to push back on a material devaluation of the CNY while concomitantly defending the currency with near-peak FX reserve deployment and incremental capital controls. While we remain explicitly bearish on China’s intermediate-to-long-term growth outlook, as well as the nation’s capital and currency markets, we continue to believe the path lower will remain piecemeal in nature, rather than sharp and/or sudden."
Indeed, it is appropriate to suggest that China has stabilized – certainly on a relative basis to über-bearish consensus expectations early in the year. This stabilization has been somewhere between a stealth driver and key catalyst of broad-based reflation across EM assets in the YTD:
- iShares MSCI Emerging Markets ETF (EEM): +14.6%
- WisdomTree Emerging Currency Fund (CEW): +7.9%
- iShares JP Morgan Emerging Markets USD Bond ETF (EMB): +9.9%
- Market Vectors Emerging Markets Local Currency Bond ETF (EMLC): +12.1%
- WisdomTree Emerging Markets Corporate Bond Fund (EMCB): +7.2%
- iShares MSCI Brazil Capped ETF (EWZ): +64.9%
- Market Vectors Russia ETF (RSX): +25.8%
- Global X FTSE Argentina 20 ETF (ARGT): +27.2%
- iShares MSCI All Peru Capped ETF (EPU): +72.7%
In the context of knowing what we knew then about the most likely path for the Chinese economy and CNY (i.e. lower but not all at once), our general bearish bias on EM throughout the YTD has been a terrible call. In the context of our #LateCycle Slowdown view of the U.S. economy and labor market (and how the Fed is likely to react to that – i.e. dovishly), our call on EM this year has been downright horrific.
Our specific long/short recommendations haven’t been quite as dreadful, but they certainly have not generated alpha this year given our preference for defensive, commodity insensitive countries and regions. But [jokingly] who cares? As has become the case with the SPY, riding the beta wave seems increasingly more important to investors than generating alpha.
Alas, we should’ve seen broad-based EM reflation coming from a mile away. As rewarding as being the axe on the bear side of EM has been since we authored the call in early 2013 (see: Chart of the Day below) is as shameful as it has felt overstaying our welcome in the YTD.
Fortuitously, this industry doesn’t leave a lot of time and space for apologies and excuse-making. Moreover, most thoughtful investors tend to focus more on what’s coming down the pike rather than what’s already occurred.
So what’s next for EM from here? Specifically with respect to China and its outsized influence on sentiment for this asset class, fundamentals for EM are decidedly mixed. That said, however, they are unlikely to be as supportive throughout 2H16 as they were in 1H16 when the Chinese economy as we know it seemingly escaped from the abyss. Specifically:
- Phony GDP data aside, it’s clear that Chinese economic growth continues to deteriorate across the preponderance of key high-frequency indicators. Negative import and export growth, as well as trending deceleration across industrial production, money supply, fixed assets investment and total social financing growth are all confirming of this conclusion.
- Bucking the aforementioned trend are China’s official manufacturing PMI and non-manufacturing PMI data. How sustainable these divergences are in the context of the conspicuously negative inflection in China’s property sector across a variety of key metrics (see: exhibits A, B, C, D, E, F and G), the ongoing culling of industrial overcapacity, as well as the sharp deceleration in disposable income growth remains to be seen.
- Fiscal policy has been very accommodative to what growth China has recorded throughout the YTD – particularly deficit spending, which has ratcheted up dramatically on a TTM basis. The pace of incremental deficit spending has slowed fairly sharply of late and base effects imply a waning tailwind to growth absent new public investment initiatives – which have already been the key driver of investment on a trending basis.
- Monetary policy has been quite accommodative as well throughout much of the YTD, but like fiscal policy, the tailwind is wearing off at the margins. Specifically, the amount of liquidity provided to the market by the PBoC via open market operations each month is now slowing on a sequential, trending and quarterly average basis.
- Despite this marginal tightening, interbank rates continue to trend lower, which is exerting downward pressure on rates across the sovereign yield curve and upon credit spreads on the mainland. That the PBoC was able to accomplish all this easing and amid stabilization in capital outflows and FX reserves speaks volumes to how impactful the Fed’s dovish pivot(s) has been to China’s balance of payments risks.
Speaking of the Fed and U.S. monetary policy – the key driver of capital flows to and from EM assets – we don’t see the Fed being able to perpetuate lower-highs in the U.S. dollar from here. They’ve already done all they can to completely root out policy normalization expectations from the market, which implies the impact of dovish rhetoric upon the currency market will be muted on a go-forward basis; they need to outright ease policy (e.g. QE or a rate cut) if they want to drive the dollar lower from here.
That the aforementioned setup is occurring in the context of both the Eurozone and Japanese economies slowing concomitantly with the U.S. would seem to imply that incremental easing out of the ECB and/or BoJ is likely to have a greater impact on currency markets than yet another dovish pivot by the Fed.
All that being said, however, I don’t know that the DXY is poised to breakout to new cycle-highs in the context of our dour view on domestic employment growth and Yellen’s sensitivity to the labor market. For now at least, the balance of risks point to slight bullish bias in the USD, though still very much range-bound. And until something material changes, I don’t know that it’s appropriate to have a ton of risk on in EM in either direction.
As such, we’re keen to book the aforementioned gains and losses in order to retreat to the sidelines until further notice. Sometimes just wiping the slate clean and getting stuff off your screens is the most effective thing an investor can do to ensure future success.
Our immediate-term Global Macro Risk Ranges are now:
UST 10yr Yield 1.45-1.61% (bearish)
SPX 2155-2186 (bullish)
VIX 11.13-14.98 (bullish)
USD 94.75-97.25 (bullish)
Oil (WTI) 39.29-43.78 (bearish)
Gold 1 (bullish)
Keep your head on a swivel,