Carmen Reinhart didn’t do emerging markets any favors last week.
As you’re undoubtedly aware, she was out suggesting that the situation is perhaps more fragile than folks realize. Specifically, here’s what she said:
The overall shape they’re in has a lot more cracks now than it did five years ago and certainly at the time of the global financial crisis. It’s both external and internal conditions. This is not gloom-and-doom, but there are a lot of internal and external vulnerabilities now that were not there during the taper tantrum.
That strikes at the heart of the ongoing debate about whether what we’ve seen in EM of late is more a product of idiosyncratic stories (e.g., Turkey and Argentina) causing broad-based jitters or whether this is the beginning of something bigger and the lira and Argentine peso were just the wobbliest dominoes, so to speak.
One thing’s for sure: what we’ve seen lately in the lira, the rupiah and the Brazilian real certainly doesn’t inspire much confidence in EM’s capacity to absorb more Fed hikes, let alone a coordinated tightening effort across developed market central banks.
And look, that’s not an attempt to spread fear, it’s just to state the obvious, which is something akin to this: “If this is what happens when the dollar picks itself up off the mat after an abysmal year and the Fed finally sounds some semblance of serious in terms of transitioning to a more data-dependent reaction function, what would happen in a sharp dollar rally and/or if DM central banks made a concerted effort to normalize?”
It’s impossible to answer that question, but given how desperate the global hunt for yield became in the post-crisis years, it’s reasonable to think that some folks are positioned more aggressively than they’d ideally like to be in some of these far-flung locales. What happens when there’s an impetus to reallocate?
“US investors’ exposure to foreign investments has surged in 2008-18, and now accounts for large portions of several non-US equity markets”, Credit Suisse writes, in their May FX outlook, before cautioning that “if the prospect of higher returns at home were to drive US investors to repatriate funds, the impact outside of the US could be significant.”
The bank does note, however, that the correlation between EM FX and U.S. yields is “not strong” especially when compared to the obvious link between developing market currencies and commodities:
Unfortunately, oil’s rise is now contributing to dollar strength (or at least not hindering the greenback’s rally) in part due to the feedback loop between inflation expectations and the Fed’s reaction function.
Still, Credit Suisse is willing to give EM the benefit of the doubt for now.
“We think [the] recent EM rout has more to do with idiosyncratic issues (e.g. elections jitters, poor BOP) and lack of adequate policy response,” they write, in the same note cited above, suggesting that for the time being, this isn’t necessarily a story about external pressure from the rising dollar and rising U.S. yields triggering an unwind.
Meanwhile, Goldman adds a little context to a recent chart rolled out by BofAML’s Michael Hartnett who suggested that when it comes to leading indicators for global profits, it doesn’t get much better than South Korean exports:
Here’s Goldman explaining the reasonably upbeat outlook for EM domestic economies in light of the recent slowdown in exports:
While the recent moves in US rates may indeed spill over into EM financial conditions (which have tightened 15bp year-to-date), so far the data across most EM economies has remained strong. In particular, we find that “domestic” data has recently outperformed “global” data – as measured by retail sales and export in goods.
The ‘2nd derivative’ of retail sales growth and exports growth have followed a similar trajectory since the start of the broad EM recovery in 2016, but since the beginning of 2018 retails sales have continued to accelerate while exports have slowed. From this perspective, we take solace that the EM “domestic” story remains resilient despite a soft patch in global data.
You can take all of that for what it’s worth, but coming full circle to Reinhart, Bob Michele, JPMorgan Asset Management’s global CIO and head of global fixed-income, thinks Carmen has a point.
Here’s what he said in an interview with Bloomberg TV:
Carmen Reinhart dropped an interesting stink bomb on the markets last week. I think she’s right. It was an innocent comment. When you look at external debt to GDP pre-crisis 2007 it was 28 percent, now it’s 39 percent. These economies have levered up and it’s not clear they can absorb higher funding rates going forward.
It’s very reminiscent of the taper tantrum. That proved to be a false dawn because rates didn’t continue rising from there. In fact, they went to new lows in 2016. This time, we don’t see that. Everything’s been thrown in reverse. You won’t see more QE. You won’t see more rate cuts. In fact, you’ll see the opposite.
Nothing further – for now.