Marko Kolanovic was right about the 2016 election when most people weren’t.
Of course that’s not surprising. Marko has a reputation for being right when everyone else isn’t, and indeed, his August 21 call for a “convergence” trade was subsequently adopted by multiple analysts and, ultimately, the mainstream financial news media.
Last week, the dollar fell, EM stocks rallied, Chinese equities soared, and two of EM FX’s problem children (the peso and the rand), posted big gains. In relative terms, it was the best week for the iShares MSCI Emerging Markets ETF versus the SPDR S&P 500 Trust ETF of the year. As far as EM FX goes, it was the best week for the MSCI gauge since February. And when it comes to China, last week was the best week since 2016 for the Shanghai Composite in relative terms (i.e., versus the S&P).
So yeah, last week was the week of the convergence trade that Kolanovic called for more than three weeks prior.
Given all of the above, you might be wondering what Marko sees next, both in terms of the midterm elections and also the convergence trade.
Well, in a note out Wednesday morning, Kolanovic lays out a simple rationale for the convergence narrative, using historical precedent in the dollar and commodities.
“Our view in favor of a rotation towards the RoW and EM is based on the premise that the global growth cycle is not over and that stresses in EM are much less severe than those leading into the 2015 crisis”, Marko writes, on the way to noting that in 2014-2016, the dollar rallied some 25%, versus the current much shallower rally.
In the same vein (i.e., making the same point) commodities plunged by 45% in 2014-2016, versus comparatively meager recent losses.
“So by these measures the current stress is five times smaller than what was experienced in the 2014-16 time period”, Marko writes, summarizing, before noting that he does “acknowledge that interest rates are higher in the recent period.”
To drive the point home, Kolanovic reminds you that while “current EM fundamentals are worse than those of DM,” recent losses in the former mean that EM “could be the best-performing assets from now to the end of the year, and still be the worst-performing assets for the year.”
As far as the midterms go, Marko reminds you that he was positive on U.S. stocks following the election due to the prospect of corporate tax cuts and deregulation. But as far as the trade war goes, the reality is that while there’s some political utility in pushing the “us versus them” narrative, the implications of current policies are clear, once you strip away the euphemisms and niceties. Here’s Kolanovic:
Trade wars effectively amount to an increase of taxes and government regulations. Governments collect tariffs (i.e., taxes) from corporate profits and consumer wallets. Regulations come via an opaque process of excluding certain businesses and interest from tariffs (the government picking winners and losers), and deciding on tariff subsidies (welfare handouts).
As far as how the midterms will likely pan out and what the implications for equities are from the various scenarios, Marko notes that a split Congress would be a good thing for U.S. equities given that “checks and balances [would be] re-introduced.” That’s generally consistent with BofAML’s take that gridlock is actually the best possible outcome.
As far as the “Red wave” goes, Kolanovic says it would be a bad thing to the extent it would likely mean “further escalations in the trade wars.” On the much ballyhooed “Blue wave”, Marko is similarly cautious to the extent it would present “increased political risks and risk for tax reform”.
So there you have it. You can (and invariably will) draw your own conclusions, but that, as ever, is an objective assessment both of the political backdrop and the extent to which the pain in emerging markets has likely run out ahead of both the fundamentals and, perhaps, rationality.