If you’re bullish on emerging market stocks (or really, on emerging market anything) right now, well then you’re a brave soul.
EM equities and EM FX suffered through their worst quarter since 2015 in Q2 and you didn’t have to look very far to find the problem(s). For one thing, a recalcitrant, unapologetic Fed continues to lean hawkish in an effort to guard against overheating in the U.S. economy, where Donald Trump is busy piling fiscal stimulus atop a late-stage expansion. Jerome Powell’s hawkishness is increasing the policy divergence between the Fed and the rest of the world, leading directly to a stronger dollar. Additionally, the fact that the Fed is running down the balance sheet at a time when Steve Mnuchin is flooding the market with new Treasury supply has the potential to suck liquidity out of the rest of the dollar bond market – just ask the RBI’s Urjit Patel.
Meanwhile, the trade war threatens to undermine the global expansion at a time when the “synchronous growth” narrative that prevailed in 2017 was already giving way to a U.S.-centric story predicated on the sugar high from Trump’s fiscal push.
On top of that, the flare-up in Argentina and the ongoing train wreck in Turkey, where the lira is collapsing amid concerns about central bank independence and whether Erdogan will be willing to take the steps necessary to arrest the currency’s slide, are a reminder that idiosyncratic risk is always lurking in the background when it comes to EM.
Through it all, there’s not much in the way of evidence to support the contention that Jerome Powell has changed his mind with regard to what he said in May at an IMF/SNB event. Here, for anyone who missed it, is what Powell said about the likely resilience of emerging markets as the Fed normalizes policy:
Monetary stimulus by the Fed and other advanced economies played a relatively limited role in the surge of capital flows to (emerging market economies) in recent years.
There is good reason to think that the normalization of monetary policy in advanced economies should continue to prove manageable for EMEs. Markets should not be surprised by our actions if the economy evolves in line with expectations.
Still, some folks are starting to think the bottom might be in. Notably, EM bulls got a vote of confidence from none other than JPMorgan’s Marko Kolanovic last week. Marko’s call is predicated on a broader thesis that includes a bullish take on value stocks and is based, in part anyway, on the idea that the Fed will ultimately be forced to take a pause. Here’s the color from Kolanovic on EM specifically:
Over the past 10 years, EM equities declined ~15% (in USD terms), trailing the S&P 500 by ~100%. Over the past 5 years, EM equity funds did not attract any new funds (close to zero net inflows), while DM equity funds attracted over $600bn of new assets. Over the past 2 months, EM equities significantly underperformed the S&P 500, and EM equity funds experienced ~$10bn in outflows. The largest part of the recent performance divergence is due to currency, where positioning also appears to be stretched. For instance, CFTC speculative futures open interest data reveals almost 3 standard deviation long positions in USD, and 1-3 standard deviation shorts across a range of EM currencies and the Euro. EM equities have been caught in a secular trend of value underperformance driven by various structural reasons (e.g., prevalence of momentum and growth investing, passive assets, decline in liquidity, competition from private equity, etc.). This trend occasionally breaks and the most recent weakness in growth stocks may help EM and value investors.
Notably, CFTC data current through last Tuesday showed speculators trimming that bullish USD bet for the first time in six weeks. As far as flows go, here’s a useful stat from Bloomberg’s Eric Balchunas:
EM is back! Past 16 weeks of EM ETF flows shows epic recovery.. pic.twitter.com/vLQk57v4RP
— Eric Balchunas (@EricBalchunas) August 6, 2018
It’s against that backdrop that Ben Inker is sounding a bullish call on EM in GMO’s latest quarterly letter. After taking you through what went wrong in the second quarter (so, after reviewing everything noted above and pointing a finger at the stronger dollar as the proximate cause), Inker goes on to explain why he thinks the dollar has likely overshot. To wit:
Clearly, if the USD continued to strengthen, it would be a negative for emerging markets. Will it happen? It is hard to dismiss the possibility. A strong US economy and rising interest rates are more likely to be associated with an expensive USD than a cheap one. But on that front, it’s worth recognizing that the USD is already pretty expensive, as we can see in Exhibit 4.
He goes on to deliver a fairly upbeat take on the fundamentals in EM before talking a bit about the prospect of an all-out trade war upending developing economy assets. While GMO notes the obvious (i.e., that emerging markets are highly exposed to a situation that sees a monkey wrench tossed into the gears of global trade and commerce), they offer the following perspective on U.S. isolationism:
It is appropriate, therefore, to be concerned about escalating trade tensions. But it is also worthwhile to keep them in perspective. At this point, the trade war that is in the offing is very much “US versus the world,” instead of “everybody versus China” or “everybody versus everybody.” This is an important distinction, because while the US is the world’s largest economy at about 25% of global GDP as of 2016, it is one of the most closed economies in the world, such that US exports are only about 12% of the global total and imports about 15% of the global total. If the US were to actually follow all the way down the current path and put tariffs on 100% of all US imports, with the rest of the world responding with tariffs of their own, the result would impact 12% to 15% of trade for the rest of the world and 100% of trade for the US. While 15% of trade isn’t immaterial, it’s hard to see how it fundamentally alters a lot of the calculus of who builds what where.
In any event, you can read the full letter below, but the bottom line in terms of their asset allocation is this:
Emerging market value stocks are the best asset we can find, by a margin that is just off of the largest we have ever seen. This large margin of superiority warrants a large position in emerging value stocks, and that is what we have in asset allocation portfolios where allowed.
Again, you’re encouraged to read the details, as there are a number of cautionary notes, caveats, etc.