Emerging Markets: The Rally Is Over

by: Evariste Lefeuvre


The recent rally in EM stocks and FX comes to an end.

External factors such as U.S. Treasury yields, U.S. dollar and global liquidity are not supportive enough.

I still recommend caution and discrimination based on local/domestic strength.

The underperformance of EM stocks against U.S. indexes is entering its fourth year (see chart below). This disconnect is not consistent with the current level of global trade of VIX. In this post, I decompose the relative return of MSCI vs. S&P 500 and gauge whether the underperformance remains justified or not.

The relative return of MSCI vs. S&P 500 can be explained by the following factors:

  1. U.S. Treasury yields: Higher interest rates lead to an underperformance of the MSCI;
  2. Base metal prices (I use the LMEX which tracks World Trade and World PMI quite well): a rise in metal prices naturally leads to an outperformance of the MSCI;
  3. The dollar (DXY index here): A stronger dollar is generally detrimental to the relative performance of the MSCI against S&P 500;
  4. Global liquidity. Contrary to what has been written many times, a rise in global liquidity, when everything is going wrong, does not tend to help EM.

I run an estimate of the model on monthly data since January 2010 (the inclusion of 2008/09 does not change the coefficient but only the scale, given the huge swings recorded in the factors' prices during the Great Recession). The chart below provides several insights:

  1. The 6-month relative performance of the MSCI vs. the S&P 500 is in the middle of the rich/cheap bounds, which suggests that there is no genuine mispricing;
  2. Yet, the upper bound of my model remains below the 0% threshold. It suggests that the macro/financial backdrop is not supportive enough to justify an outperformance of EM against U.S. stocks.

3-month returns are showing some different patterns, both for the MSCI (chart left below) and for the MSCI BRIC (right chart below). In both cases, the 3-month relative performance is positive but above the upper bracket of the model. It suggests that the recent rebound has slightly overshot its target.

In spite of the recent dead cat bounce of EM markets, the broad picture remains only mildly supportive for a sustainable outperformance of the MSCI EM against the S&P 500. Given the coefficients assigned to the factors of the model, the outlook remains bleak: for year end, I still expect rising long U.S. treasury yields, a strengthening of the USD and lower metals prices. This combination would clearly put a lid on EM stocks.

To make matters worse, many of the traditional cross asset relationships involving EM stocks have imploded.

This is particularly the case for the EM/S&P 500 vs. copper/gold: the recent outperformance of EM stocks is not consistent with the upward move of the gold-to-copper ratio.

The EM/S&P 500 vs. U.S. Treasuries (TLO below) is not helpful: given the price action of the TLO (U.S. Treasury note), the SPY ETF should have outperformed the EEM ETF.

In both cases, the correlation breaks are so preposterous that no genuine signal can be extracted.

Bottom line: The recent outperformance of EM stocks against the S&P 500 is consistent with the fall in U.S. long term interest rates and a slightly weaker dollar. Barring a significant regime switch, the odds for a long lasting outperformance of EM markets against U.S. indexes remain quite low. While I do not rule out significant interest in EM stocks, I am now more ready than ever to recommend some serious discrimination based, notably, on domestic strength.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.