Emerging Divergences

Emerging Divergences

Emerging market contagion was the topic of discussion this week in the financial press. While U.S. equity indexes retreated (tech stocks a bit more), we can hardly talk about a spillover of the debacle in many emerging markets, with the S&P 500 down less than 1% for the week. Fear over a new round of Trump tariffs on China was kindled Friday after Trump said he’s ready to impose tariffs on an additional $267 billion in Chinese goods on short notice, on top of a proposed $200 billion that his administration is putting the final touches on. Hours earlier, Larry Kudlow proposed that Trump is willing to meet with Chinese leader Xi Jinping if Beijing shows it’s open to compromise. Kudlow had said that the Trump team will evaluate the comments and make a decision in terms of the volume, tariff rate and timing. Sounds like Trump is again making threats to gain negotiating power, and sending markets into turmoil in the meantime. So as we close out the week, another Trade War fear driven market.

We had a busy week for macroeconomic data. The Trade Balance for July came out mid-week and the numbers are not looking good for Trump who has made reducing the U.S. trade deficit one of his main economic goals. Signs are emerging that the president’s trade wars are starting to hit economic growth, not just at home but around the world. Wednesday we learned that the U.S. trade deficit in July widened at its fastest rate since 2015 (-$50.1 billion) as monthly deficits with China and the European Union both hit new records. In the year so far, the U.S.’s overall goods and services deficit is up by $22 billion, or 7 percent, versus the same period last year. It turns out that even GDP reflects Trump trade policy…and not necessarily in a healthy way. Last week we reported that U.S. GDP jumped an annualized +4.2% in Q2. The trade report showed that, while soybean farmers are widely seen as one of the likely victims of a trade war with China, a surge in exports of soybeans to get ahead of new tariffs helped boost U.S. GDP growth in the second quarter. According to this week’s trade report, in the first seven months of this year, the value of U.S. soybean exports actually increased by more than 40 percent, or $5.7 billion, versus the same period last year.

These distortions are likely to be temporary. We believe U.S. GDP growth may have peaked at 4.2 percent in second quarter, with trade likely to be a drag on growth in the months to come. Even as Trump launches his tariff battles in the name of reducing the U.S.’s imbalances, he has been causing the overall deficit to grow by increasing public spending and encouraging domestic investment.

The first week of the month also brings the PMI and employment data. The ISM PMI Manufacturing index jumped to 61.3 in August, the highest reading this economic expansion. The ISM PMI Services index also improved in August (58.5 from 55.7). And Non-Farm Payrolls grew 201k in August (vs 190k creations expected) and the employment rate ticking up to 3.9% as more workers rejoined the labour force. Wages are picked up in August, +2.9% y/y vs. +2.7% y/y the prior month. Solid economic data, as the economy is clicking on all cylinders. We are starting to sense that strong economic data, especially price data, will again start to be bad news for the markets. The Federal Reserve will be hiking rates based on strong data. Fed doves like James Bullard will have to come around to the interest rate hike camp should data keeps coming in this strong. It will be Fed rate hikes that finally put the nail in the coffin of the equity bull market.

The Great Divide: Emerging Markets and the U.S.

This week, more emerging markets have entered bear market territory. From the 2018 closing high peak to this week’s trough, the MSCI Emerging Markets index is now down exactly -20.01%. Taking a quick tour of emerging market indexes, here is where we stand.

Several EM indexes had crazy run-ups over the past few years: India, Chile, Argentina, South Africa, Thailand, Indonesia, Philippines, and Hungary. We note that, with the exception of India, which is still seeing near parabolic buying this year, most of these indexes exploded into 2013 and have gone sideways with an upward drift.

Others were in more healthy up-trends until recent EM selling. These indexes broke above prior bull market highs (generally 2007), but without seeing the excesses (taking the U.S. indexes as our standard of “excess”) or panic buying: Brazil, Turkey, Mexico, Chile, and Malaysia.

Still others have failed to re-take prior bull market highs (generally 2007): Poland, Czech, Russia, Peru, Colombia, China, and Singapore.

To put this in perspective, the S&P 500 is +86% above the 2007 high, the Nasdaq-100 is +242% above the 2007 high, and the Russell 2000 is +249% above the 2007 high. Indeed, financials where a drag on the S&P 500 this bull market. The S&P 500 ex-Financials Index is 168% above the 2007 high. No other major/investable world index comes close to the exaggeration in the U.S. indexes.

The next chart is staggering. We took the MSCI Emerging Markets Index relative to the S&P 500 and took the chart back to 1987. Like the tide, emerging market stocks and U.S. stocks relative performance rises and falls. We are at low tide for EM stocks and high tide for U.S. stocks. Asset allocators should be moving out of U.S. stocks and into EM stocks, in preparation for the next rising tide. Timing the absolute bottom here is a fool’s mission. Being approximately right (shifting in EM stocks) is better than being absolutely wrong (staying in U.S. stocks and going against the tide for years).

Of note also this week, the South African economy just officially entered recession. However the local FTSE/JSE index is just barely off its highs. We esteem that this is due both to the multinational constitution of companies in the index and the fact that only a recession of the world + U.S. economies will affect stock markets globally. Our first assertion is validated by the performance of the FTSE/JSE Small Cap Index (more sensitive to the South Africa economy). The small cap index peaked in March 2017 and is down -15.5%.

So why are relatively attractive EM indexes falling out of bed while expensive U.S. stocks just keep getting more expensive as Mr. Johnny-Come-Lately piles in? The root of the Emerging Market turmoil is the tightening of Federal Reserve policy. Many emerging countries peg their currencies to the U.S. dollar. When U.S. rates rise, emerging country central banks are forced to raise their rates as well to maintain the currency peg. But their economies can not stand higher rates as can the U.S. economy.

As readers can imagine, the real damage to EM markets is being done on the currency markets. Versus the U.S. dollar through Thursday night, here is a sample of EM disasters.

The collapse in so many EM currencies is, first of all, not unusual (think back to the Asian Crisis of 1998), and second, is an enormous opportunity for USD and EUR-based investors. We track a basket of currencies contained in the JP Morgan EM Local Currency Bond ETF (EMLC). We use this vehicle to get instant market exposure to EM currencies (and get paid a monthly coupon for holding the currencies). Here is a chart of our currency index since 2000. Yes, it takes intestinal fortitude to put on a long EM currency trade here. And you are not going to pick the bottom. But versus a position long Russell 2000 or Nasdaq, in 2-3 years time, you’ll be happy to have bought the EMLC currencies.

News off the wires reports that Argentina will propose that central banks from developed nations be allowed to purchase sovereign bonds from emerging markets and hold them as reserves. Central bank president Luis Caputo will travel to Basel this weekend to make the pitch at a meeting of central bank chiefs. In theory central banks from major economies could hold 2% of their reserves in EM sovereign bonds. This would obviously be a huge tailwind for the EMLC, which is 96% invested in sovereign bonds of Brazil, Poland, Mexico, Indonesia, South Africa, Thailand, Colombia, Russia, Malaysia, and Czech Republic.

Long EMLC is a trade that we hope to put on in the coming weeks. However we’d like to wait a bit more for rates to back up in emerging countries a bit more as the Fed tightens. While the EM currencies are already attractive, we are still in the early innings on this EM crisis and contagion to developed markets has yet to occur. This is a trade to hold your fire on “until you see the whites of the enemy’s eyes” so to speak. We’ll announce when we begin moving EM currencies into our DRG Strategy.

Former Federal Reserve Chairman Alan Greenspan asked 20 years ago this week, during 1998 during the Asian Crisis, whether the U.S. could remain an oasis of prosperity in an increasingly fraught world economy. We know the answer, if history holds true. If we define the beginning of the Asian Crisis in June 1997 when the Thai Baht began to collapse, U.S. risk assets were eventually affected, but after putting up a good resistance. The S&P 500 had a couple down days in October 1997 (-10% draw-down) until rallying further into July 1998 when the S&P 500 had a rapid bear market (-20% draw-down). We don’t expect developed equities to avoid serious difficultly if this EM crisis goes further.

The world financial markets are much more interconnected today than in 1997-98. Moreover, U.S. valuations are much more stretched today than in 1997-98, if we use Shiller’s CAPE P/E. In 1997-98 the Shiller P/E was between 28.33 and 32.86. Today we are at 33.07. Past is prologue.

Conclusion

We are not sure if we’re insane for not wanting to join the ride in the Nasdaq or if others are insane for ignoring recent history. Nevertheless, we firmly believe that contagion is a normal reaction if the crisis in EM market persists (which will need the Fed to continue hiking rates and Trump to push forward with tariffs at any cost). Moreover, fearing a collapse in EM markets today and not fearing a bursting of the U.S. equity bubble seems utterly irrational. For us, buy-the-dip is U.S. equities is over. We like buying the rout in EM stocks and currencies for the long haul.

Trade Recommendation

We went long the MSCI Brazil this week on both selling exhaustion in the real vs dollar and political development in Brazil. Brazilian presidential elections were jolted Thursday when the leading candidate, the controversial former Army officer Jair Bolsonaro, was stabbed during a street rally in the country’s heartland. The attack threw what had already been a raucous race into an even greater state of turmoil. By Thursday evening, the right-wing lawmaker’s condition had stabilized and Brazilian traders, who are partial to the candidate’s free-market stance, had placed bets the incident would fuel outpourings of sympathy and help propel him to the presidency.

In addition, the real is at 2015 lows, and a double bottom is possible here.

The MSCI Brazil (EWZ tracker) gives exposure to both the Brazilian currency and Brazilian stocks. The EWZ in U.S. dollars has obviously fallen more than the Bovespa of late. At 2017 and 2018 lows, this is worth a shot on the presidential election news. This is a “news-driven bottom-fishing trade”, so stops are in place.

 

 


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