You can count BofAML in camp that thinks an emerging market rally is likely in the cards.
Last week, JPMorgan’s Marko Kolanovic flagged what he characterized as an “unprecedented divergence” between U.S. stocks and the rest of the world. That divergence is explainable by reference to U.S. fiscal and trade policies which are bullish for the dollar (and therefore bearish for emerging markets) and also bullish for U.S. stocks, which have benefited from the effects of the tax cut “sugar high” (e.g., buybacks and record earnings).
According to Marko, “something has to give” going forward, and that “something” is likely to be dollar strength. Global non-banks are sitting on an implicit $11.5 trillion dollar short and ongoing greenback strength threatens to expose EMs that have borrowed heavily in foreign currencies.
The dollar is caught in a self-feeding loop thanks largely to Donald Trump and now, he (Trump) seems intent on short-circuiting that loop, although not in the interest of buoying ex-U.S. risk assets, but rather in the interest of “winning” his trade war.
Whatever his motivations, to the extent he can engineer a pause in the dollar’s ascent it would be welcome news for emerging markets and for ex-U.S. risk sentiment more generally.
(The dollar has rallied strongly off the February lows, piling pressure on developing economies and exposing the weakest links in the EM complex)
Generally speaking, analysts are still clinging to the notion that the Trump administration will deescalate trade tensions with China in the interest of avoiding a scenario where additional tariffs drive consumer prices in the U.S. higher forcing the Fed to lean more hawkish and giving the dollar an excuse to extend its rally. More dollar strength could plunge EM into an outright crisis, which could boomerang back and finally hit U.S. stocks just as the adrenaline from the stimulus wears off. Clearly, that’s not a desirable outcome ahead of the midterms.
Now, with the clock ticking down on the imposition of duties on an additional $200 billion in Chinese goods, BofAML expects a reprieve. In a note dated Monday, the bank says they expect the U.S. midterms to be “a winner for EM”. To wit:
The fiscal stimulus package and trade tensions have been closely linked to the approaching elections and have weighed on EM so far. Trade wars have become by far the most feared risk, according to our monthly investor survey. Now, however, [we] expect an imminent NAFTA deal and some progress with China, as the polls suggest that the US administration has a strong incentive to present good news on trade. Importantly, we expect the next round of China tariffs scheduled for Sep 6 to lapse as they would be too painful for the US consumer and the agricultural heartland (via China retaliation).
For my part, I continue to believe that’s the wrong way to think about the Trump administration’s trade “strategy”. While the President may be able to allay some fears in the farm belt by presenting positive news on the trade front, it is by no means clear that the base is willing to abandon him just because the deleterious effects of the trade war are showing up at home. Indeed, some farmers have recently suggested they’re willing to suffer “to the death” for Trump. More generally, I don’t think Trump really wants to “win” this “war”. Rather, I think he wants to fight it in perpetuity in order to legitimize his platform. There’s more on that in “Dream States: Why No Resolution To Current Political Conflicts Is Possible“.
Regardless of what you believe, there’s no question that the dollar is what’s going to be paramount for EM going forward and while that’s self-evident, BofAML breaks it down a bit in the interest of driving the point home.
“Time and again a weaker USD dominates any other EM driver, whether global or local [and] chart 2 shows this on the basis of monthly correlations of EM returns with the USD and other potential drivers”, the bank writes, adding that “this has also been the case during periods of Fed tightening [as] monthly EM returns have surprisingly been negatively correlated with the G3 central bank balance sheet.”
The bottom line for BofAML is that in their minds, the dollar rally has peaked for 2018. Here’s why:
- Trade war fears seem to have become USD positive lately, so their easing should be USD negative.
- The US-EU data surprise differential seems to have peaked too for now.
- Positioning in US vs rest-of-the-world assets is back to historical highs.
Make of that what you will, but do note that even if you buy into it (figuratively or literally), the bank thinks it will likely be short-lived:
We expect a post-summer EM rally – though a tactical one before global risk assets, this time including the US, come under pressure in 2019.