Posts tagged Emerging Markets
The S&P 500 has taken something of a breather this past month. After notching yet another all-time record on March 1, the index has mostly been content to tread water while the animal spirits of investors’ limbic brains wrestle with the rational processors in their prefrontal cortices. This past Tuesday’s pullback – gasp, more than one percent! – brought out a number of obituaries on the Trump trade. We imagine those obits might be a bit premature. As we write this, we do not know whether today’s planned House vote on the so-called American Health Care Act will pass or not (let alone what its subsequent fate would be in the Senate). But markets appear tightly coiled and ready to spring forth with another bout of head-scratching giddiness if enough Members, ever fearful of a mean tweet from 1600 Pennsylvania – knuckle under and find their inner “yea.” An outcome we would find wholly unsurprising.
Risk On with an Asterisk
If the melt-up is still going strong, we might want to look farther out on the risk frontier to see how traditionally more volatile assets are faring. All else being equal, a “risk-on” sentiment should facilitate a favorable environment for the likes of small cap stocks and emerging markets. Here, though, we have a somewhat mixed picture. The chart below illustrates the year-to-date performance of small caps and EM relative to the S&P 500.
In a time where US interest rates are expected to rise and the fortunes of export-dependent developing economies are at the mercy of developed-market protectionist sentiments beyond their control, emerging markets are going gangbusters. Meanwhile domestic small caps, which could plausibly be equated to more of a pure play on an “America first” theme, are languishing with almost no price gains for the year. This seems odd. What’s going on?
Rubles and Pesos and Rands, Oh My!
We’ll start with emerging markets, where the driving force is crystal clear even if the reasons behind it are not. The Brazilian real is up about seven percent against the dollar this year, while the much-beleaguered South African rand has enjoyed a nine percent tailwind over the past three months. Seven of the ten top-performing foreign currencies against the US dollar this year come from emerging markets. So when you look at the outperformance of EM equities in the above chart (which shows dollar-denominated performance), understand that a big chunk of that outperformance is pure currency. Not all – there is still some outperformance in local currency terms – but to a large extent this is an FX story. Moreover, it is not necessarily an FX story based on some inherently favorable conditions in these countries that would lead to stronger currencies. It is much more about a pullback of late in the US dollar’s bull run, a trend which has surprised and puzzled a number of onlookers. Whether you believe the EM equity rally has lots more fuel behind it comes down to whether you believe the dollar’s recent weakness is temporary and likely, on the basis of fundamentals, to reverse in the coming weeks or months.
Value Stocks Running on Empty
Back in the world of US small caps, the performance of the Russell 2000 index shown in the above chart owes much of its listless energy to…well, energy. Namely, the small energy exploration & development companies that populate a good proportion of the value side of the small cap spectrum. Value stocks were more or less holding their own through the first two months of the year (though still underperforming large caps), but they got hit hard when oil prices plunged in the early part of this month.
And it’s not just oil and energy commodities, but also industrial metals that have weakened in recent weeks, leaving shares in the materials and industrial sectors – high fliers in the early days of the reflation trade – underperforming the broader market. So this leaves investors to ponder what exactly is left of the tailwinds that drove this trade. The Republicans’ clumsy handling of their first big policy test – repealing and replacing a law they’ve been calling doom on for seven years – may signal a much larger dollop of execution risk (for all those tax and infrastructure dreams) than baked into current prices.
On the other hand, one could make the case that tax reform – likely the next item on the policy agenda – is less complicated than healthcare. If a consensus builds around the idea that Tax Santa is arriving sooner rather than later, one could expect at least one more brisk uptrend for the reflation trade. That outcome could very well catalyze a reversal of the performance trends shown in the above chart, with emerging markets pulling back while small caps gain the upper hand. Of course, there is always the option of staying focused on the long term, and playing through the noise of the moment without getting sucked into the siren song of market timing.
The big news after last month’s National People’s Congress in Beijing was the announcement by Premier Li Keqiang of the government’s intention to set a range, rather than an individual target, for annual real GDP growth. The range was to be between 6.5 and 7.0 percent, seen as striking a balance between the admission that a steady rate of seven percent, the previous target, was not sustainable, while still delivering enough top-line growth to reach the country’s GDP targets for 2020. Today China released its GDP results for the first quarter of 2016 and – lo and behold – the number came in at 6.7 percent. Observers met the release with the usual skepticism over how much the reported figure varied from what is actually going on in the world’s second largest economy. We’re less concerned about whether the “real” top line is 6.7 or 7.0 or even 5.5 percent, and more concerned about what recent data tell us about the progress, or lack thereof, towards China’s much ballyhooed economic rebalancing.
More Bridges to Nowhere?
Specifically, much of the data released since the March NPC meeting points to an apparently deliberate decision on the part of Beijing policymakers to reach for the elixir of investment-driven stimulus – the key growth driver for much of the past 10-plus years – as a way to head off concerns that efforts to rebalance towards a more domestic consumption-driven economy may be falling short. Those concerns have manifested in recent months in the form of massive capital outflows and a resulting 20 percent decline from peak foreign exchange reserves. Premier Li’s NPC remarks reflected the view that a sugar fix is the best response. Markets took note: iron ore prices jumped by a ridiculous amount on the Monday after the NPC, and commodities generally surged in anticipation of a pickup in China demand. Were they right? Consider the chart below showing other recent key data releases.
Among these four charts, you can see the sharpest reversal of recent trends in industrial production and wholesale prices, both of which came in comfortably ahead of analyst expectations. Fixed asset growth – a key metric for China’s activity in infrastructure and property development – is still nowhere near the levels of recent years, but has actually increased for the first time since 2014. Meanwhile the growth rate of retail sales, an important benchmark of consumer activity, is lower than at any time in the past twelve months.
Corporate Debt – China’s Mountain Dew
Fixed asset investment doesn’t happen without infusions of new debt capital. New bank loans in China are up $351 billion in March, on the heels of an even brisker pace of $385 billion in January new loan creation. That January number represents the fastest pace of monthly loan growth on record. While January is often the busiest month of the year for new loan creation, with newly-approved projects tapping their sources of credit financing, the strong follow-up in March raises expectations that China’s outstanding debt will continue to set new high ground. Bear in mind that China’s total non-financial debt to GDP has soared from around 100 percent of GDP in 2009, at the outset of a new bank lending stimulus program, to 250 percent of GDP today.
The aggregate level of debt is not the only concern; much of the lending is still tied to the so-called “zombies” – troubled state-owned companies whose loans constitute a potentially significant credit quality problem for the banks that originate them. Bankruptcies and loan write-downs are a delicate matter in China, and reminiscent of the chronically inept way Japan’s financial institutions and regulators tried to deal with that country’s nonperforming debt problems in the 1990s.
When the Sugar Wears Off
All sugar highs come to an end, a fact not lost on Beijing’s Mandarins. We do not think it is on anyone’s agenda to try and embark on another decade of hypergrowth fueled by bank loans and fixed asset investment. The Mountain Dew is meant to buy some time and give the urban services sector a chance to establish enough momentum to take over as the economy’s growth engine. This is China’s own version of “kick the can,” a game in which almost every globally significant economy has indulged over the past seven years. For the time being we expect the China story to be net-neutral to positive in its contribution to the overall market narrative, premised on expectations of no imminent hard landing and a stimulative effect on commodities prices. Come autumn, though, policymakers may need to show they have an effective antidote to the sugar high.
The home page for Barron’s online this morning is an instructive sign of the times. One of the lead articles is headlined thus: “Investors Regain Interest in U.S. Stocks,” going on to talk about a $4.6 billion of net inflows into global equity ETFs and mutual funds in the past week. Just two articles below that happy headline is a somewhat more dour take on things: “Unprecedented Outflows from U.S. Stocks Could Leave Remaining Investors Holding the Bag.” It may be the best of times, it may be the worst of times, but in any case it does appear to be a remarkably confusing time.
With that confusion in mind, let us consider Brazil. The once-high flying South American bellwether is rarely far from the top of the headline stream in both the financial and the political sections of major media outlets. Investors with the stomach for event risk, though, have little to complain about in the first quarter-and-a-bit of this year. The chart below shows the price performance of the domestic Bovespa stock index for the year to date.
No Country for the Weak of Heart
The Bovespa is up an impressive 37 percent from its low for the year reached on January 26. Over the course of this rally we have learned the following pieces of information about Brazil: Real GDP in 2015 fell by 3.8 percent, the most in 25 years; the magnitude of GDP decline from peak to trough is 7.2 percent, the worst since the 1930s; and the economy is set to shrink another four percent in 2016. Inflation is over 10 percent, and the total public debt to GDP is over 70 percent, a level not compatible with the country’s existing socio-economic commitments.
All of which is to say nothing of the toxic political climate, long mired in a financial corruption scandal surrounding Petrobras, the national oil concern. Brazilian President Dilma Rousseff has fought attempts by opposition lawmakers to bring impeachment charges against her for some time. She appears to be losing the fight with the defection of three political parties from the coalition led by her Workers’ Party (PT), most notable of which is the Brazilian Democratic Movement (PMDB) led by Michel Temer. With polls showing around 70 percent of the population supporting impeachment, Rousseff may find herself at least temporarily out of power before the end of this month.
Salto do Gato Morto
Given the dire state of both the economy and the political system, can the current rally in the Bovespa be anything other than a dead cat bounce (approximately translated into Portuguese above)? The bullish case would start with the observation that oversold assets will attract mean reversion at some point. The Bovespa is currently around 49 percent below the post-2008 high reached in November 2010. Does that qualify as “oversold”? Perhaps yes, if one assumes that the likelihood of a Dilma Rousseff exit – with PMDB head Temer as the potential replacement – is fully priced into current levels. This outlook would also be premised on the view that the wrenching GDP retreat will bottom out in 2016, that a weak currency will give a tailwind to exports and that a stabilization in commodity prices will boost the economically important resource sector.
Of course there is no certainty that events will play out to such a tidy resolution of the current problems. The PMDB is hardly a squeaky-clean political establishment; six of its members including both the upper house and lower house speakers are under investigation in the Petrobras affair. Nearly 60 percent of the Congress is under some form of criminal investigation for a range of misdeeds including homicide. On the economic side of things the banking system, which has stayed relatively intact amidst the general gloom, may be vulnerable (especially the large public sector banks) to growing capital adequacy pressures if the recession doesn’t trough in the near term.
For those who missed the Bovespa ride in the first quarter, we would be skeptical of any tactical overlay opportunities for the coming months and view the potential case for Brazil as net-negative. For those with a taste for wading back into riskier LatAm equities, we are somewhat more favorably disposed towards Brazil’s neighbor to the south. Argentina is returning to international capital markets next week after a 15 year exile, with a global bond offering investors expect to fetch between $12-15 billion. The proceeds from this offering will be applied to repaying a consortium of creditors led by U.S. hedge fund Elliott Management, on which the prior Argentine government defaulted in 2001. Observers expect that a successful bond offering next week will pave the way for Argentina’s ability to return to global debt markets at least once more later this year.
Argentina’s Merval stock index has also fared well this year, with the latest close about 28 percent above its January low. But whereas Brazil faces a daunting challenge to recapture the performance of its glory days in the early years of this decade, Argentina’s new reformist government could potentially be the catalyst for significant upside ahead after the many years in the wilderness under the previous isolationist government of Christina Kirchner. Not without risk, of course – Argentina has broken the hearts of many an investor going back to the Baring Crisis of 1890. On the other hand, as a Russian proverb has it, no risk means no Champagne.
Animal spirits are running high in the month of March to date. A whole dealer’s choice of assets ranging from global stocks to crude oil to the South African rand and Turkish new lira are all climbing out of the depths of despair in which they had been mired for most of the first two months of the year. For the time being, anyway, it appears to be a moment for the long-suffering to shine. While emerging markets and energy & production stocks have their day in the sun, the so-called “Nifty Nine” and other darlings of 2015 languish. The MSCI Emerging Markets index is up 5.4 percent since the month began, and more than thirteen percent above the six and a half year low point reached back on January 21. Bargain hunters quite naturally sniff a deal: is it one worth taking?
The Rally in Context
Thirteen percent is nothing to sneeze at, but it remains a long way even from relatively recent high water marks. The chart below illustrates the price performance of the MSCI Emerging Markets index over the past ten years. The dotted horizontal lines represent, respectively, the pre-recession all-time high (2007), post-recession high (2011) and last two years’ high (2014).
Investors viewing emerging markets from a tactical standpoint would probably look with most interest at that last two years’ number: even after the recent rally, the index is still more than 28 percent away from the L2Y high point reached in September of 2014. That’s a lot of ground, which arguably means that tactical investors could take comfort in not having missed the boat. Double-digit annual gains would not necessarily be out of the question with the right combination of EM-friendly tailwinds.
Not Much New Under the Sun
Chief among those tailwinds would likely be a continued run-up in energy and industrial metals prices, a strengthening of local currencies against the US dollar, and a general absence of bad-news surprises principally from China, but also from other suffering EM locales including Brazil and Russia. A glance at the headlines in the month to date, though, suggests that not much has really changed in the fundamental landscape of the global economy. The recent rally in crude prices, arguably (if unusually) the principal catalyst in equity strength, is based less on a real improvement in the global supply-demand balance than on atmospherics about what oil ministers will say to each other when they (supposedly) meet later this month. China’s recent headline numbers have been less than impressive, including capital outflows, weak industrial production and sagging imports and exports. Brazil’s recession is turning deeper than expected, while the ongoing Petrobras political scandal has now ensnared the country’s former president, Luiz Inácio Lula da Silva. Perhaps the brightest recent news tidbit from emerging markets comes from the unlikely source of Argentina. That longstanding pariah appears ready to return to the capital markets after the new government of Mauricio Macri settled a longstanding debt dispute with major creditors earlier this week.
In our commentary last week we suggested not getting too comfortable even while enjoying the fruits of the recent global equities rally. We would extend that cautionary note even more emphatically to emerging markets. While the above chart shows enticing new ground to break on the upside, there is plenty of potential downside as well. In a market environment driven largely by whichever lurking X-factors pop into or out of existence like so much antimatter, the next big move could be either way.
There has been almost nothing “happy” about the New Year thus far. It’s probably a good thing that investors had a whole weekend in which to shake off New Year’s Day hangovers before showing up to face a sea of red arrows on Monday morning. Those red arrows, of course, came courtesy of yet another series of bafflingly inept moves by Beijing’s financial policymakers. It would be an exaggeration to say that the world’s second largest economy is in a swoon, but its financial markets certainly are.
But while the dramatic pullback in world equity markets and rising volatility are strong reasons to give pause, we do not believe this is the right time to pull the panic switch. While unquestionably a critically important component of the global economy, China depends on other world markets for its exports more than other world markets depend on China’s domestic demand for their own fortunes. Moreover, the fortunes of US companies still depend more on the US consumer than anything else. This year may provide a decisive answer to the question of whether the US economy can continue to prosper as the world’s growth engine despite increasing weakness elsewhere. We don’t yet know that answer – but based on the data we have on hand, we are not ready to jump into the lifeboats. If today’s environment bears any resemblance to past periods, we think more of 1997-98, and less of 2007-08. It is worth revisiting what happened back then before we conclude with our thoughts on the current market.
Asian Currencies, Act I
The Asian currency crisis of 1997 had an effect on equity markets around the world, including the US. The chart below shows the price performance of the MSCI All Counties Asia Pacific index from January 1997 to December 1998, versus the S&P 500 for the same time period.
The carnage in Asia was fast and brutal, with currencies falling as much as 40 percent against the dollar, and regional stock exchanges losing as much as 60 percent. As the above chart shows the S&P 500 (in green) suffered a rapid succession of pullbacks of 5 percent or greater between the summer of 1997 and January 1998 (the pullbacks are indicated in the chart along with the magnitude of each peak-to-trough drawdown). These pullbacks came on the heels of a near-10 percent correction that took place before the currency crisis. Many investors at the time interpreted this shaky performance – in the context of a deeply troubled global economy – as presaging an end to the bull market that had run nearly uninterrupted since early 1995. Asia was seen as the world’s emerging growth region, with great promise for US companies to manufacture, source labor and materials, and sell to the fast-growing middle class households in the region. The currency crisis threatened to bring a swift end to the good times and to provide a headwind to US companies’ EPS growth.
Russia Unleashes the Bears
As dire as the currency crisis was for Asian markets, which continued to fall through most of 1998, the US channeled its inner Taylor Swift and “shook it off” to rally strongly through the first half of 1998. Investors’ focus turned away from turmoil elsewhere to focus on the strength of the domestic US market, particularly the tech boom riding on the Internet’s penetration into commerce and social life. Then another foreign time bomb went off in August, when Russia devalued its currency and defaulted on its sovereign debt obligations. Another massive selloff took place in US equities – this one approaching the 20 percent threshold for a bear market. Caught up in the Russia collapse was the hedge fund Long Term Capital Management, which over the course of a tense few days threatened to turn this pullback into a genuine pandemic.
After all the drama, though, it turned out that the best way for investors in US stocks to navigate these two volatile years was to…do nothing at all. The S&P 500 registered a 66 percent cumulative price gain from the beginning of 1997 to the end of 1998. It was undoubtedly tempting to sell out at various critical junctures, but patience and discipline were rewarded.
Asian Currencies, Act II
Asian currencies are once again at the center of things. Most fell sharply against the dollar last year, though so far by generally less than they did in 1997. The Malaysian ringgit, for example, is about 23 percent lower versus the dollar over the past twelve months, and the Thai baht is softer by some 11 percent. Of course, this time it is the China renminbi – largely not a factor in the ’97 crisis – that is the center of focus. The RMB has devalued by just over six percent from where it was before the first bout of devaluation last August. What should not be forgotten, however, is that the renminbi was largely flat against the dollar in the first half of 2015, while the euro and other developed and EM currencies were falling.
Also worth remembering is that China as well as its Asia EM neighbors are in far stronger FX reserve positions today than they were in 1997. The threat of a debt default by any regional government is considerably more remote than it was nineteen years ago. China’s policymakers may demonstrate a tin ear when it comes to considering the likely short term impact of their decisions on world financial markets, but it is hard to imagine them making the kind of policy mistake that would trigger a real economic freefall.
And that brings us to China’s real economy. All the drama this week started with a below-consensus manufacturing report representing a fifth month of contraction. At the same time, though, recent indicators of consumer activity have been good – retail sales have been growing at double-digit rates for most of the last twelve months. If China’s economic transition is going to succeed, it is going to succeed thanks to the consumer, so these trends are absolutely consequential to the larger picture.
And if China does export price deflation to other markets through a weaker currency? Well, lower prices for China imports could be stimulative for US consumer activity. As we said earlier, what is good for the US consumer will likely be good for US stocks. Admittedly, this is a rational argument being made at the end of an irrational week. We may not be out of the woods as far as the current pullback is concerned. But we are not panicking.