Shaking The Tree: The Fed, ‘Overripe Fruit’ And A Half-Full Snifter

If you’re following along, you know that the key question for EM as the Fed tightens, as the dollar rallies and as U.S. yields rise, is this: are recent stumbles primarily attributable to idiosyncratic stories in Turkey and Argentina or does that characterization get the causality wrong? That’s actually two questions. If the answer to the latter question is “yes”, well then what’s really going on is that the external shock from a determined Fed, a stronger dollar and rising U.S. rates is the controlling factor and the crises in Turkey and Argentina represent what happens when a shift in the macro environment begins to weigh on the EM complex more generally.

That’s an excerpt from a (very) recent piece penned by one my favorite market commentators: me.

When someone asks me who I’m consulting with when it comes to my breathless analysis, I can generally answer that by quoting America’s not-so-venerable, would-be autocrat:

I’m speaking with myself, number one, because I have a very good brain and I’ve said a lot of things.

To quote Trump again, “I listen to a lot of other people” too and “at the appropriate time I’ll tell you who the people are.”

Sunday seems like an “appropriate time” to tell you that I’ve been “listening” to a couple of recent pieces from Deutsche Bank and Goldman when it comes to the prevailing emerging market narrative as outlined above by “myself” and my “very good brain” (which is probably less “very good” than it would be had I not spent a couple of decades drowning the synapses in Laphroaig).

My argument, generally, is that the problem isn’t country-specific risk in Turkey and Argentina spilling over into the broader EM complex. Rather, my contention is that EM is reacting to higher U.S. rates, a stronger dollar and, more to the point, a determined Fed. EM is littered with idiosyncratic, country-specific risks, all of which will eventually be exposed if the Fed tightens too aggressively – it just so happens that Turkey and Argentina were the “overripe fruit”. Here’s Deutsche Bank from a noted dated May 23:

We should not over complicate the macro picture. A starting point should be that every Fed tightening cycle creates a meaningful crisis somewhere, often external but usually with some domestic (US) fall out. Fed tightening can be likened to the monetary authorities shaking a tree with some overripe fruit. It is usually not totally obvious what will fall out, but that there is ‘fall out’ should be no surprise. Going back in history – 2004/6 Fed tightening looked benign but the US housing collapse set off contagion and a near collapse of the global financial system dwarfing all post-war crises. The late 1990s Fed stop start tightening included the Asia crisis, LTCM and Russia collapse, and when tightening resumed, the pop of the equity bubble. The early 1993-4 tightening phase included bond market turmoil and the Mexican crisis. The late 1980s tightening ushered along the S&L crisis. Greenspan’s first fumbled tightening in 1987 helped trigger Black Monday, before the Fed eased and ‘the Greenspan put’ took off in earnest. The early 80s included the LDC/Latam debt crisis and Conti Illinois collapse. The 1970s stagflation tightening was when the Fed was behind ‘the curve’ and where inflation masked a prolonged decline in real asset prices.

Of course this tightening cycle isn’t exactly a spring chicken. How have things managed to hold up this long?

Well clearly, the fact that a variety of factors have conspired to keep financial conditions loose despite multiple Fed hikes has helped tremendously. So too has the careful maintenance of the Fed-market two-way communication loop, which precipitates the low vol. regime. Amusingly, expectations of ECB tightening actually helped keep things stable in 2017. As the eurozone economy continued to perform well and as Draghi continued to acknowledge that performance (see the Sintra “tantrum”), a policy convergence narrative replaced the policy divergence narrative, which in turn served to underpin the euro and in conjunction with jitters about the viability of Trump’s fiscal agenda, helped push the dollar lower last year. Here’s Deutsche Bank again, from the same note cited above:

As an example, at the moment there are a host of idiosyncratic stories in EM that look to be largely tangential victims. Where the US rate cycle is relevant is that the past extreme external policy accommodation can no longer mask domestic issues including valuation extremes like compressed credit spreads. That the USD was going down initially as US rates went up also gave the appearance that ‘this time is different’ and a benign Fed tightening cycle would ensue.

Now, the dollar’s correlation with yields has been restored as has the policy divergence narrative (i.e., the eurozone economy is decelerating and giving rise to questions about the feasibility of an ECB exit while the Fed remains on track).

The tree, as Deutsche puts it, is being shaken and so far, the fallout has been reasonably contained. Here’s EM FX and equities with the recent stumble highlighted:

And here’s EM spreads (16-month high):

Ok, so just to underscore the notion that this is primarily about the Fed, the dollar and U.S. yields and not so much about spillover from idiosyncratic stories, I thought I’d bring in a couple of passages and charts from Goldman which, in a piece dated Friday, writes that while there’s been “particular focus on the ‘hot-spots’ of Argentina and Turkey (and Russia before that), the major driver of this sell-off is an unfriendly external backdrop (rising USD and US rates), as opposed to vulnerabilities across the EM landscape.”

To support that conclusion, they look at a simple model of EM returns expressed as a function of the dollar, the S&P, 10Y Treasury yields and oil prices. Here are a couple of visuals:

Clearly, EM credit is the standout there. Goldman attributes that to “stretched starting valuations” and the presence of a “Frontier vs. EM phenomenon”. They then explore that at length, but their overall takeaway is this:

[What] we aim to highlight here is that EM FX, EM Equity, and EM local rates have “behaved” very well relative to their global betas vis-a-vis DM asset prices. Looking a bit more closely, it is fair to say that EM assets have underperformed their ‘betas’ since mid-April, but we view this as simple mean-reversion from the strong outperformance vs. the model from December and January.

Implicit in that is the notion that the factors in the model will move back in favor of EMs for the balance of the year (otherwise, their exercise would be an effort to effectively  goal-seek a bearish narrative).

“The EM sell-off can be very well explained through broad DM asset moves – which we think will reverse (i.e. weaker USD, stronger S&P 500) and drive EM higher in 2H 2018,” Goldman concludes.

So there are two ways to look at this. If you’re a snifter is half-full (of Hennessy) type, then the fact that EM FX, equity and local rates performance is consistent with recent moves in DM assets is actually a good thing because the dollar strength will abate and U.S. stocks will move higher into the second half of the year, supporting EM.

If you’re a snifter is half-empty (refill it now) type, well then this is actually a bad thing because dollar strength is likely to continue, leading to an ongoing tightening of financial conditions and the continual shaking of the proverbial tree.

Draw your own conclusions.