By Gavekal Capital Blog
Over the weekend a long-time client asked an excellent question related to our recent blog post entitled, "Is a Bright Spot Emerging in the Global Equity Markets?", in which we tediously documented the relative out-performance trends among the vast majority of emerging market countries. The client correctly highlighted another notable divergence from trend being the US dollar falling instead of rising, and asked if this was the key ingredient to EM out-performance.
As it turns out, the premise of dollar weakness driving EM out-performance is a good one. Indeed, that is how it usually works. Chart 1 below shows our GKCI EM index vs our GKCI DM index (left axis, blue line) overlaid on the USD index (right axis, red line, inverted). When the dollar falls, EMs outperform and vice versa. To some extent the dollar selling off has helped EMs outperform DMs, but under the surface there are some interesting anomalies that suggest other factors at work too.
For example, the rally in EM relative performance has been driven by counter cyclical stocks, not cyclical stocks, which are the largest beneficiaries of dollar weakness (charts 2 & 3). In chart 4 we can see both dynamics at play as we compare EM counter cyclicals to EM cyclicals (blue line, left axis) and then overlay the dollar index (red line, right axis).
With the dollar selling off we would have expected EM cyclicals to outperform counter cyclicals, but we've seen the exact opposite. We can thank falling interest rates for this.
Chart 5 below compares EM counter cyclicals to EM cyclicals (blue line, left axis) and then overlays US 10 year treasury bond yields (red line, right axis, inverted). Counter cyclicals, in EM or DM, outperform cyclicals when yields fall, period.
So it may just be that EM counter cyclicals find themselves in a sweet spot of sorts in which they benefit to some extent from a weaker dollar and to a large extent from lower rates. With 2016 Fed rate hike expectations having fallen from 4 hikes to 2 hikes over the last few weeks and then Yellen floating the negative rate trial balloon last week, we could make a case for continued EM counter cyclical out-performance. Indeed, further rates hikes may be unpalatable to the FOMC unless something dramatically changes with regard to market implied inflation expectations (chart 6), which have plummeted to 2009 levels.