There are many risks out there. Emerging markets causing market chaos (forget US stocks are at all time highs and could care less), rising trade tensions threatening long-established world trade patterns and disrupting company supply-chains.
That’s from a client note penned by Chris Rupkey, MUFG Union Bank’s chief financial economist, and it speaks to how difficult it is these days to try and pen concise posts summarizing the current market narrative.
The list of embedded contingencies feels like it’s expanding faster than the universe itself and the most vexing part of the whole thing is that virtually all of the risk factors feed into one another, creating a series of self-fulfilling prophecies that themselves overlap.
Just think, for instance, about the emerging market problem. At heart, it’s a story about the reversal of the post-crisis hunt for yield that drove investors down the quality ladder and out the risk curve. As the Fed tightens and USD short-rates rise, carry trades are unwinding rapidly, playing havoc with developing economies that have borrowed heavily in foreign currencies. Here’s EM FX vol. versus G7 FX vol.:
And here’s Goldman, from a piece out earlier this week:
Steady rate hikes and an accelerating pace of balance sheet runoff have raised concern that the Fed’s tightening is more than the world—and emerging markets in particular—can take. The fear is not unreasonable: EM crises have occurred often during past Fed tightening cycles, and the special role of US monetary policy in the global financial cycle has grown further since then. Our Financial Conditions Index framework shows that hawkish Fed surprises tend to tighten EM financial conditions, and that the magnitude of these spillovers is fairly volatile. At times, spillovers from the Fed have contributed, alongside domestic vulnerabilities, to EM crises.
This is well worn territory but you wouldn’t know it, because it keeps happening over and over again and every, single time, somebody out there acts surprised.
It should have been even less surprising this time around, given the sheer scope of the post-crisis hunt for yield engendered by a decade of ultra accommodative DM policies.
“Excess liquidity usually leads to the misallocation of capital, masking any balance sheet constraints [and] as this tide of excess liquidity recedes it reveals the misallocation of capital and the mispricing of risk”, Nedbank’s Neels Heyneke and Mehul Daya wrote, in a recent flash note that is basically a reiteration of everything they’ve been attempting to warn folks about all year long.
“For EMs over the past couple of years we’ve seen fundamentals drift back to close to where they were in 2009/10, as reflected in their aggregate sovereign ratings [and] yet, investors have allocated large amounts of their portfolio allocations to EM’s relative to DM markets”, the Nedbank duo continues, adding the following color that once again highlights their $-Liquidity indicator:
A stronger USD is usually associated with volatility and a risk-off phase as liquidity contracts. Since the start of the year the supply of USDs have become scarce amid escalating tit-for-tat trade policies, slowing credit growth in China, and weaker commodity prices. The Federal Reserve and the US Treasury also drained USD’s from the financial system. This can be seen clearly in our Global Broad $-Liquidity indicator.
This process is exacerbated by U.S. fiscal policy which has all at once pigeonholed the Fed (late-cycle stimulus raises the chances that the Phillips curve snaps back to life with a vengeance) and driven U.S. equities inexorably higher (tax cuts catalyze record buybacks and boost corporate bottom lines).
The Fed, wary of an inflation overshoot spurred by piling stimulus atop an economy operating at full employment, has to hike. That drives rate differentials in favor of the dollar, which strengthens commensurately. That, in turn, weighs on emerging markets, and puts EM policymakers in a position where they have to choose between hiking to protect their currencies at the risk of choking off growth and imperiling domestic equity markets, or keeping policy loose and chancing a currency crisis.
In case you haven’t noticed, hikes haven’t necessarily been working for EM policymakers. Argentina has hiked to a cartoonish 60% to no avail for the beleaguered peso and notably, 125bps worth of hikes by Bank Indonesia since May has been unsuccessful in stabilizing the rupiah:
Meanwhile, the same U.S. fiscal stimulus that’s driving the dollar higher propels the U.S. economy, thus perpetuating divergent growth outcomes and giving investors even more of an excuse to abandon EM in favor of U.S. assets. On top of all that, U.S. trade policy is gasoline on the fire, because the risk of protectionism simultaneously imperils global growth (EM -) and pushes up domestic prices stateside (prompting an even more hawkish Fed, USD +).
As if this needed to get any more complicated, the Trump administration’s foreign policy, depending as it does on unilateral sanctions, adds an extra layer of unpredictability with the potential to derail EM even further as we saw last month with Turkey (sanctions tied to the Andrew Brunson debacle) and Russia (proposed sanctions tied to all manner of things, including, hilariously, meddling in an election on behalf of the same administration that’s now leveling the sanctions).
The whole thing is giant Venn diagram and trying to explain one part of it without reference to the rest of it is almost impossible. Every post ends up sounding like a caffeine/coke-induced rant…
You’ll note that when it comes to EM, the next big risk is the introduction by the Trump administration of tariffs on an additional $200 billion in Chinese goods. The comment period expired on Thursday and frankly, I’m actually surprised there hasn’t been any word from the USTR yet.
The only way this gets any better for EM in the near-term is if the Fed takes a pause and although no one thinks that’s in the cards this month, you have to wonder what the conversation is going to be inside the FOMC in the event things continue to deteriorate for developing economies over the next couple of weeks. Maybe someone will break out a cork board with maps and red markers and pins and strings on the way to explaining just how all of this is inextricably bound up with itself.
In any event, I’ll just end this rant with Goldman’s list of factors that have caused them to revisit their “broadly constructive view on EM economies and asset prices”…
- A moderation in DM growth: Following a period of sustained acceleration between 2016Q1 and 2017Q4 – during which our Developed Market (DM) Current Activity Indicator (CAI) rose from +1.4% to +3.5% – DM growth has slowed this year, to 3.0% in the 3 months to July. Even at this lower level, DM growth is still tracking above its post-crisis averages (+2.1%). Nevertheless, on a sequential basis, the slowdown in DM activity represents a negative impulse to EM growth.
- Tighter EM and global financial conditions: Having eased significantly between late 2016 and early 2018, EM and global financial conditions have tightened materially since February. This tightening, which has been triggered by a reappraisal of US rate prospects, has been driven by higher global long-term interest rates and a decline in global equity prices.
- Energy prices have risen: Oil prices have risen more than 20% since 2017Q4 (and are 50% higher than this time last year). For oil-exporting EM economies, the rise is beneficial. But, for oil-importing EMs, the negative effect of rising oil prices is typically larger than for DM economies, because output in less developed economies tends to be relatively energy-intensive.
- Tariffs and the risk of a ‘trade war’: The tariffs that have been introduced to date are limited in scope but the US has announced plans to introduce more significant measures, targeting China in particular, while China has announced a series of retaliatory actions. The direct effects of the measures announced so far appear manageable. However, the prospect of rising barriers to trade has weighed on asset prices, most notably in China, and the indirect effects on global business confidence and investment could be substantial.