We’ve talked incessantly about the risk of getting too complacent in emerging markets after a stellar Q1 for anything with an “EM” prefix.
Those who need (or want) a refresher are encouraged to see the latest here:
- The “Curious Curse Of May”: Here’s Where The Risks Are
- Don’t Look Now, But Something Cracked On Tuesday
- It’s “Make-Or-Break Time” And We Could See “A Painful Cleanout”
Simply put, there’s every reason to believe what we’ve seen so far this year in EM is unsustainable, although in a note out Tuesday, Deutsche Bank seems to disagree. To wit:
We do not expect seasonality to be a major driver of EM FX this May because 1) May returns are not always negative; 2) EM FX has not followed seasonal patterns thus far in 2017; 3) Key external variables (DXY and S&P) have not followed seasonal patterns this year either; 4) Less ‘payback’ from April performance for EM FX in 2017; 5) External environment is still broadly supportive for EM FX.
So we suppose that’s something of a counterargument.
But for those who, like Bloomberg’s Mark Cudmore in the third post linked above, think we might be due for something of a “painful cleanout,” BofAML has what the bank calls “4 key factors which argue for a more nuanced view” on risk assets going forward. Note that point #1 is precisely the same point we made here.
Also, this is supposed to be applicable to risk assets in general but as you’ll see, there’s a particular emphasis on EM. More below…
The View As good as it gets
Risk assets are performing well and investors are clearly bullish. This is not without reason, fundamental data is pointing to a cyclical upturn, EBIDTA earnings growth in EM is strong, earnings revisions are up and existentialist threats such as protectionism and the European project are being dialed back. Nevertheless, we advise caution and this month is especially notorious for its refrain to “Sell in May”. Aside from the negative seasonality for risk assets and overextended positioning, we highlight four key factors, which argue for a more nuanced view.
#1) China H2 slowdown amid de-leveraging By most measures, emerging markets are undergoing a broad based recovery led by developed markets. However, we are warning that China could see deterioration in growth and credit conditions in H2. This view is shared by our Chief China economist, Chief Asia strategist and China banking analyst. Indeed, China’s latest PMI reading for April may be showing the first inkling of slower growth momentum, with new orders falling, albeit still at an expansionary pace. The risk remains that the PBoC will tighten monetary policy further to rein in excessive financial leverage, resulting in slower H2 China growth. Given this H2 China risk, coupled with limited upside for energy prices (see point 3), we are reluctant to chase 18 consecutive weeks of inflows into EM markets. Instead, we prefer being selective in LDM, buying bonds in India, Indonesia and Peru and paying Colombia 1y, Czech 5y swaps and Poland 1y2y swaps. We stay short BRL/ARS, short EURPLN, buy TRY/ZAR and biased short MXN, CNY and KRW.
#2) US deficits vs. curve trades We note that traditional US yield curve models suggest a higher deficit outlook result in steeper 5s-30s UST curve. However, we find that a 50bp rise in 2y yields would offset the steepening impact of 1% deterioration in forward deficits. A 50bps rise in 2yr yields is conceivable if the resulting fiscal stimulus allows the Fed to hike much faster. This means that conditional bear steepeners only make sense if coupled with front-end OTM puts. Moreover, fixed income investors may not necessarily find safety in short duration positions, especially if US/Eurozone core inflation accelerates faster than our base line.
#3) Trump’s energy policy may weigh on EM Energy is one key policy in Trump’s agenda that investors risk losing sight of amid the understandable focus on tax reform and fiscal stimulus. We point out that President Trump will be very motivated to deliver on energy reform and deregulation as it would create jobs in key states important for next year’s mid-term elections. Moreover, NAFTA’s renegotiation could boost energy supply as well as demand in North America. The upshot is that this could be a stabilizing force for energy prices with important implications for EM energy producers as well.
#4) North Korea Geopolitical tail risk Finally, the issue of an escalating geo-political tension with North Korea still looms over summer. We have outlined four broad scenarios in our viewpoint, arguing for KRW’s risk premium to persist.