Things have taken a decisive turn for the worst in emerging markets after a brief, mid-August reprieve.
September is up for grabs in terms of what will ultimately drive performance across assets, with the dollar being the most obvious choice when it comes to what will tip the scales one way or another for risk appetite. Mercifully, the greenback took a breather in mid-August helping EM recover a bit, but over the past week, dollar strength has shown back up.
Meanwhile, EM sentiment has soured anew following a fresh leg lower in the Argentine peso, more pressure on the Turkish lira, election jitters in Brazil and, on Tuesday, a selloff in the rand following news that South Africa has fallen into a recession for the first time since 2009. Here’s the JPM EM FX index and you can see the stabilization in mid-August and the renewed pressure over the past week or so:
You might want to hide the children for the next visual, which is just the month-to-date breakdown across EM (you can take “breakdown” figuratively or literally here):
Argentina, Turkey, Brazil and South Africa are grabbing most of the headlines, but don’t forget about Indonesia (I can’t tell you how many times I’ve said that this year). They’re struggling mightily to relieve the pressure on the rupiah, which slid to its weakest levels since 1998 this week, despite multiple rate hikes since May and all manner of intervention by the central bank. The country now intends to put the brakes on some $25 billion worth of power projects in an effort to get a handle on the widening current-account deficit, which is the key source of concern in the current environment. The iShares MSCI Indonesia ETF dove by more than 4% on Tuesday. That’s the second time in a month the vehicle has suffered a one-day loss in excess of 4%:
Key to how this evolves (or maybe “devolves” is better) will likely be how the trade war plays out over the next week. The Trump administration is said to be all set to move ahead with tariffs on an additional $200 billion in Chinese goods as soon as the comment period ends this week and there’s still no resolution on the auto tariffs issue with Europe.
Trade tensions have played dollar positive since midway through 2018 and that seems likely to be the case for the foreseeable future.
“Our principal component analysis suggests the US dollar is back again the most important driver of local rates in Asia, CEEMEA and Latin America, followed by the renminbi, and EUR and US swap curves”, BNP writes, in a note dated Tuesday, adding that “systemic risk is high given the first market component explains on average almost 70% of the variability of EM rates.” Here’s a bit more and do note the last sentence:
Long-term US real rates, breakevens, and crude oil, three factors with considerable explanatory power just three months ago, rank considerably lower now. Turkey and Brazil appear to have decoupled, but there is still a substantial systemic factor embedded in local rate performance. We continue to think global liquidity and US financial conditions are not at disruptive levels, and do not justify the extent of the recent sell-off in emerging markets. Rather, contagion from the commercial channel and trade tensions via the strengthening of the US dollar have been the main driver of EM performance.
Finally, Bloomberg’s Ye Xie notes that it’s pretty rare to see the U.S. economy humming along like it is currently while EM crumbles as it is now. Here’s the MSCI EM equities index (YoY change) with the ISM level, to illustrate the point: