If you’re looking to justify a bullish take on EM in 2019, you’re probably inclined to cite the likelihood of a softer dollar.
EM bulls generally hope the Fed’s dovish pivot and a deceleration (but not a “hard landing”) in the US economy will together push the greenback lower, loosening financial conditions, reinvigorating carry trades and bolstering the prospects for developing economy assets.
For much of 2018, the US was running what BofAML dubbed “a trifecta of dollar-positive macro policies”. Here’s how that worked (from a note published late last summer):
- Easy fiscal policy pushes up the dollar by boosting interest rates and stimulating imports. The new tax laws also create incentives to repatriate cash to the US and if these monies are not already in dollar assets, this could strength the dollar as well.
- Fed tightening also pushes up interest rates, boosting the dollar.
- And actual and threatened US tariffs strengthen the dollar as well. Tariffs tend to weaken imports, reducing US demand for foreign currency, and threatened tariffs add to global uncertainty, pushing up safe-haven currencies like the dollar.
All of that fed on itself last year (get it? “fed”?), to the detriment of EM equities and FX. At one point in August, when the lira was in a death spiral, it looked like emerging markets were on the brink of an outright collapse.
Fast forward to February and the US data has indeed begun to show signs of weakness (Friday’s blockbuster jobs report and better-than-expected ISM print notwithstanding) and the Fed has of course pivoted notably dovish. In Q4, multiple Wall Street banks (not to mention Jeff Gundlach) suggested the greenback had likely peaked.
But the dollar has actually risen since the January Fed meeting and is in fact riding a five-session win streak. Meanwhile, options suggest traders are getting more bullish (bottom pane below).
Unfortunately, getting a “clean” read on positioning is difficult thanks to the fact that the shutdown put CFTC data on a delay.
In any case, those seeking clarity on the fate of the carry trade and EM in general are likely to be left in the lurch for a while given the uncertainty surrounding the trade negotiations (and thereby the outlook for global growth) and also due to the fact that how the dollar (and Treasurys) trade going forward will depend in part on whether things get even more contentious between Trump and Democrats as the debt ceiling discussion starts to heat up.
All of the above serves as the backdrop for a new note from Nedbank’s Neels Heyneke and Mehul Daya who have been keen on documenting trends in dollar liquidity and the ramifications for emerging market assets since things started to go awry in Q2 2018. They’ve also spent quite a bit of time discussing how changes in global growth affect dollar liquidity and thereby markets. Here they are recapping in a note dated Tuesday:
In 2018, rising US interest rates, combined with a strong USD (a contraction in Global $-Liquidity) and escalating trade tensions, were accompanied by an intensification of financial market volatility. As a result, EMs’ contagion risks spread and those EMs most exposed to the external environment experienced large portfolio outflows followed by large currency depreciations, widening bond yields and poor stock market performance.
They go on to remind you about the mechanics of the relationship between global growth and the viability of carry trades.
“When the global economy is growing, it generates excess USD that then circulates into the global financial system, [improving] Global $-Liquidity and [bolstering] carry trades [which] become attractive amid the allure of a weaker USD and as funding costs remain low/stable”, they note, adding that the “the opposite is also true.”
EM obviously benefited from the surge in risk assets engineered by the Fed in January. In case you’ve been away from the desk for a month, EM equities are sitting near the highest levels since August and MSCI’s gauge of EM FX rose to the highest since June.
Now, the question is whether this is sustainable. The answer, for Nedbank anyway, is probably not.
“We believe a period of portfolio inflows/outperformance of carry trades will be difficult to sustain, unlike in previous cycles”, the bank warns, citing the following headwinds:
- Global $-Liquidity remains under pressure,
- global growth is slowing,
- there is more evidence suggesting China’s reluctance to engineer another short-term credit-fueled growth boom, and lastly,
- policy makers’ ability to coordinate and reflate the global economy has become constrained in the current geopolitical-populist environment.
Heyneke and Daya aren’t alone in questioning the sustainability of recently buoyant EM assets. For instance, Credit Suisse’s Kasper Bartholdy worries that most of the good news is already “in the bag.”
“Donald Trump and Jay Powell gave holders of risk assets everything they could realistically have hoped for last week, and risks assets duly responded positively, but now face a challenging transition in which the flow of big-ticket new policy support for credit and equity markets is slowing down while the flow of growth readings from across the world continues to emit mixed signals about global growth”, Bartholdy wrote Wednesday, in a note aptly entitled “Needing more manna from heaven.”
In case it’s not clear enough from the above, Credit Suisse thinks it’s very possible that all the good news (whether it’s an assumed positive outcome on trade and/or an accommodative Fed) is already in the price after January’s surge.
From here, “the ability of risk assets to continue to rally hinges on either lazy momentum or other types of risk-supportive news, such as reports of new stimulus measures in China or a positive turn in key growth indicators in Europe or Asia”, Bartholdy goes on to write, before cautioning that “China’s policy-makers, who are on holiday this week, do not seem to have made a decision to embark on substantial leverage-building, and a notable positive turn in the growth data currently seems to be underway only in the US.”
There you go.
In the same vein (and this kind of brings us full circle back to where we started), it’s possible that all the factors which were set to weigh on the dollar have already run their course. After all, the Bloomberg dollar index was riding a three-month losing streak headed in February.