“Carry” On, But This Is One “Slippery Slope”

Our message on emerging markets is as simple as it’s been consistent.

You can read the latest here: “An ‘Emerging’ Disaster Or ‘Carry’ On: You Decide

In short, persistent inflows and YTD outperformance set against a backdrop of DM central banks looking for excuses to normalize and a deleveraging China looks like a recipe for disaster.

Flows

(Deutsche Bank)

To us, it doesn’t seem like there’s a whole lot of room for error here. The entire EM complex looks priced to perfection and it seems implausible (or at least unlikely) that emerging “anything” can remain bulletproof as the Fed hikes, the ECB leans hawkish in the face of better data, and, perhaps most importantly, China puts the brakes on credit expansion.

Indeed, there’s an argument to be made that the only reason the turmoil in China hasn’t spread to EM more generally is because the FX transmission channel has been short-circuited by a remarkably stable yuan.

But relative FX stability aside, there are all kinds of ways that China’s tightening efforts can spill over. For instance, the unwind of shadow credit channels could spark further commodities carnage which would likely weigh on EM.

Or, it could simply be that the global credit impulse will roll over as China tightens, an eventuality which could dent sentiment.

Finally, the PBoC could overplay its hand, effectively braking too hard and causing the Chinese economy to falter.

With regard to that latter possibility, consider the following out today from a Citi note entitled “EM Party Carries On, But It’s A Slippery Slope.” The excerpts below quite clearly suggest (and illustrate) that one of the main risks to the carry party is China’s tightrope walk.

Via Citi

China is another risk. As a matter of fact, looking at Figure 5 (total return in EM carry strategy vs. the Li Keqiang index), the importance of this latest large credit impulse out of China becomes more than glaring.

A rebound in EM FX carry strategies lagged the rebound in China economic activity by 3-4 months. We do worry about any disruption around the deleveraging of formerly ‘off-balance sheet’ assets in the Chinese banking sector. That looks like an important theme to be monitored in the coming months. A mild deceleration of the very large impulses seen in the past quarters may be not that detrimental for EM risk, provided that global growth risk (global equities) remains sustained. A hard landing process, as China rolls off from the credit impulse period, can be extremely negative for EM risk.

ChinaCitiEM

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