The selloff in global credit and equity markets stalled last week, and has in the most recent days been replaced by a tentative recovery after the sturdy US retail sales report that came out Friday the 12th, and after the announcement, Sunday the 14th, by China's central bank governor that he saw no need for CNY devaluation. Credit spreads are too wide at present given none of the credit negative events actually gained momentum over the last two weeks. While it certainly is a possibility that credit spread widening resumes after ECB, for now I think markets will stay balanced until the 10th of March. As a result, last week has been all about licking wounds and pushing risk higher as commodities strengthened their foothold.
The most obvious factor that had the potential to stop the climb in credit spreads was the possible emergence of a batch of US growth data that would surprise the market on the upside. Last Friday's solid US retail sales figure pulled in that direction. So did the most recent reading for ISM new orders, which was ignored by investors because it was released around the same time that came as an array of weaker than expected US growth readings, including weak GDP figures for Q4 2015.
The Chinese financial markets reopened for trading Monday of last week after being closed for the Chinese New Year celebrations. Encouragingly, the central bank has opted, through its fix, to keep the Yuan within the band it's held for more than a year. Plus, strong data for bank credit suggest that a stimulus ramp-up may be in the making. The main factor that will determine the relative performance of EM local-currency debt against EM dollar debt is the performance of the EM currencies.
Right now, the key arguments in support of EM FX are that real GDP growth in the US now has come to look almost as bad by historical standards as has EM real GDP growth, the risk of a Chinese devaluation is falling, and commodity prices are holding up well. Given the price action of the last two weeks, I think it is now safe to conclude volatility in emerging markets has somewhat subsided. Today's (Feb. 22) mini Yuan devaluation proved to be a good test of emerging market strength, and it seems both FX and equities have passed the test.
As regards the first of these arguments, its key underpinning is that the risk of Fed rate hikes has dwindled. The result is a weakening of the case - based on the expectation of widening interest rate differentials - for dollar strength against the euro and the yen. The dollar has in practice depreciated against the euro and the yen this month as the main driver of changes in those interest rate differentials has been a fall in dollar rates.
Any additional dollar-depreciation against the euro and the yen in the coming weeks would be likely, everything else being equal, to help EM currencies strengthen against the dollar. The performance of EM currencies against the dollar is not a function only of the dollar's performance against the euro and the yen. In the context of weak global equity markets during the first two trading weeks in February, commodity prices held up remarkably well.
They have historically tended to do so during periods in which the dollar has depreciated notably against the euro and the yen, and oil prices have been supported by news stories of negotiations between the governments of Saudi Arabia and Russia about possible production restrictions. I do not think these factors can be relied upon to continue to hold up commodity prices in the current environment.
To the extent that investors are selling the dollar based on concerns about US recession risk it seems to us sensible to expect them to sell commodities as well on the back of the same recession risk - at least until it becomes clearer that US growth is rebounding or that the Chinese stimulus efforts are working. As regards the negotiations between Russia and Saudi Arabia, the announcements that they have produced until now are fairly vacuous and we do not expect this to change.
As a result, I think Emerging Market currencies are overdue a 5-7% correction on average as well as strength in local bonds and strong gains in local equities. The best way to get exposure in Emerging Markets is the widely traded iShares MSCI Emerging Markets ETF (NYSEARCA:EEM). Alternatives are the Vanguard Emerging Markets ETF (NYSEARCA:VWO) AND the WisdomTree Emerging Markets Equity Income ETF (NYSEARCA:DEM).
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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