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‘Linked By A Common Thread’: Why One Analyst Isn’t Buying The EM Bull Story For 2019

"The plunge in EM asset values and localized crises (Turkey, Argentina) are not unconnected."

Who’s excited about emerging markets in 2019?!

Nobody, really. I mean, yes, people are relatively upbeat about EM headed into the new year on the assumption that the economic divergence between the U.S. and the RoW is set to close and the Fed’s assumed dovish pivot is generally seen as limiting further dollar upside (to the benefit of beleaguered EM assets), but “relatively upbeat” is something different from “excited.”

From where I’m sitting, emerging market bull calls for the new year rest predominately on the above-mentioned assumptions about U.S. growth catching down to the rest of the world and the dollar having peaked, and while those are indeed decent arguments for an RV trade (especially in light of this year’s underperformance), major headwinds for EM remain squarely in play.

For one thing, China’s economy continues to decelerate and that is bad news for EM. Here’s a chart that shows relative performance of EM equities with China’s GDP:

ChinaGDPVsEM

(Bloomberg)

I don’t know about you, but that makes me a bit cautious on EM equities up to and until there is a meaningful resolution to the trade war that has some hope of lasting beyond the next tweet from “Tariff man.”

More generally, the trade war’s effects on global growth are starting to show up all over the place and just about the last thing you want if you’re an emerging market bull is for global growth to roll over in earnest. The fact that the U.S. economy is slowing too is likely to be small comfort in that environment and could in fact make things worse, unless it catalyzes a severe downdraft in the dollar.

In his year-ahead outlook piece, SocGen’s Jason Daw is perceptibly cautious. And it’s not just growth/China jitters that have him concerned. Remember, part of the EM debate in 2018 centered around whether the idiosyncratic blowups in Turkey and Argentina were primarily the result of country-specific factors or were more a function of the post-crisis carry regime finally coming to an unceremonious end amid tighter liquidity conditions and ongoing Fed hikes. Obviously, country-specific issues were at play for the lira and the peso, but those were hardly the only currencies that came under fire. The rupiah, the rand, the real and the rupee (to name a few) were all under siege as well. The above-mentioned Daw underscores this.

“EM assets performed superbly in 2016-17 in the early stage of Fed tightening when there was an alignment of supportive fundamentals and cyclical conditions [but] the piper got paid in 2018 (FX, credit, equities, and bonds all fell) amid deterioration in cyclical growth conditions and late-cycle Fed tightening”, Daw writes, before warning that “these macro factors will remain at play in 2019.”

The key point is that all of this can be traced to liquidity or, in this case, a lack thereof. Here’s Daw again:

The plunge in EM asset values and localized crises (Turkey, Argentina) are not unconnected, but rather linked by a common thread – less generous liquidity conditions. The transition out of a decade of extremely easy money cannot go smoothly. We learned this in 2018 and in previous cycles. As the process is still unfolding, investment behaviour will continue to adjust to this new reality.

Right. And that, right there, is what’s critical in the new year. Here’s a simple illustration that drives home the point:

Tighter

(Bloomberg)

And as far as the China-global liquidity nexus is concerned, we’ll leave you with an annotated visual explainer from Nomura’s Charlie McElligott.

ChinaLiquidity

(Nomura, Bloomberg)

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