Well, the “convergence/divergence” market debate has officially gone mainstream.
On Monday, the Wall Street Journal ran a piece called “U.S. Stocks Widen Lead Over Rest of the World“, which essentially rehashes the whole “divergence” story for anyone who is inexplicably inclined to waiting around on WSJ to pick up on last month’s market narrative.
The last couple of weeks have seemingly played into the convergence theme, with some folks suggesting that a commodities rally, a pullback in the dollar and the resurgence of the global reflation story could help ex-U.S. assets catch up to their U.S. counterparts.
The caveats are myriad. Arguably, nothing has really changed for EM, other than policymakers demonstrating their willingness to hike rates in step with the Fed. The vulnerabilities (e.g., external funding needs, questions about central bank independence in certain locales, the threat of U.S. sanctions and the possibility that trade frictions dent global growth) remain.
That suggests that if the convergence trade is viable, it’s more a tactical call than a fundamental story, although I suppose one could argue that depending on the market, valuations are now compelling compared to the U.S.
In any event, Goldman is out with a sweeping new piece that documents the history of U.S.-EM divergences and it’s worth highlighting a couple of excerpts and visuals here.
First, the bank notes that divergences between the S&P and other assets are either anomalous or reasonably frequent, depending on how far back in history you want to go.
“The 2003-2010 period (both on the way up and way down in risk prices) was very coordinated in that the S&P 500 rarely moved away from EM and EAFE (non-US DM), commodity prices, and EM credit/FX (measured by the EMBI/GBI-EM)”, the bank writes, before noting that “going further back, to the 1980s and 1990s, there are many more episodes of divergence between the S&P 500 and other assets.” That speaks to rising cross-asset correlations, by the way. Here’s a visual:
The next logical question with regard to the U.S.-EM divergence is how this usually plays out. Goldman has you covered via the following table that documents nearly a dozen instances of SPX versus EM divergences and traces how they were ultimately “resolved” (or not):
“A concrete take-away from the historical playbook is that divergence tends to result in EM rallying (8 of the 10 episodes)”, Goldman writes, describing the table before noting that “half of these rallies are substantial in length (12 months or longer) and half are relatively short-lived (~4 months) [while] the remaining 2 episodes of divergence resulted in both the S&P 500 and MSCI EM selling-off”.
By process of elimination (in terms of possible outcomes), the takeaway is that at least in that sample, the S&P never simply collapses to EM’s “reality”.
Here are two charts which essentially rollup all of the information in that table into something that’s more readily digestible:
Note the chart in the right pane there. That’s consistent with the idea that EM can convergence with the S&P without the latter selling off. That’s particularly germane in the current context, given that as the impulse from fiscal stimulus in the U.S. wanes, stateside equities are going to lose one of the factors that has inoculated U.S. assets from the malaise in emerging economies.
Unsurprisingly, the key to how these divergences ultimately play out is EM growth. Here’s Goldman:
Looking at subsequent growth trajectories, the ‘resolution’ periods are quite straightforward. If we look at divergence episodes that resulted in EM catching up to some degree, they involve a recovering in EM GDP growth. Conversely, the episodes that end in EM (and the S&P 500) selling off further tend to coincide with a further slide in EM growth.
And see, that right there may be critical going forward. U.S. trade policy is all at once threatening the outlook for global growth and serving as an impetus for a hawkish lean from the Fed (think: tariff-related price pressures). Both of those outcomes (slower global growth and a hawkish Fed) are EM negative.
Goldman notes that history doesn’t suggest the U.S. growth trajectory matters much in terms of how this resolves itself. That is, if the U.S. economy continues to hit on all cylinders, that needn’t be an impediment to EM catching up. What would be an impediment, though, is a sharp deceleration in global growth catalyzed, for instance, by further trade frictions.
And with that, we’ll just say in closing that on Monday, Christine Lagarde indicated the IMF is set to downgrade their outlook for global growth.