The fading out of the Trumpflation rally in US markets gave the chance to emerging market (EM) equities to take the lead this year. Still, the time is getting closer to the point where US equities (NYSEARCA:SPY) will start outperforming their emerging market counterparts (NYSEARCA:EEM) in dollar terms again. Either the current rebalancing effort of many EM economies under a new domestic monetary tightening cycle will result in their eventual downfall, or the reflationary trade will resume in the US by unleashing another up-leg in share prices and the US dollar (NYSEARCA:UUP). In either case, the emerging market equities priced in dollar terms will most certainly fall behind their US peers, reversing their year-to-date gains. While it is virtually impossible to predict how exactly the Trump administration will move in certain economic policy areas, it seems that the EM world has more to lose than the US, given its great dependence on global trade, growth and cheap USD funding. Something will have to give. It's either global growth and trade or USD funding. However, investors seem to be expecting the smallest volatility gap between EM and US share prices in the last 13 months or so. This complacency means that if global growth disappoints or off-shore funding stresses arise, investors could be unpleasantly surprised by a burst in EM equity and currency volatility, the first hints of which have already arrived.
Shipping Index Signals A Possible EM Bearish Story
The election of Donald Trump as the new president of the US has broken a pretty solid negative correlation between the relative performance of US equities with respect to their EM peers and the global dry shipping market. Now, it seems that the time has come for this negative relationship to resume itself in favor of the US equities.
Throughout almost all of 2016, the strong uptrend in the Baltic Dry Index (BDI), a gauge of dry shipping costs across the most popular global sea routes, went hand in hand with the outperformance of emerging market equities. The outperformance of EM equities was evident in the downtrend of the ratio of SPY over EEM. The drop in this ratio meant that the MSCI Emerging Markets Index expressed in dollar terms was performing much better than the S&P 500 index. This trend materialized due to two factors. Firstly, EM equities rebounded strongly from their previous plummet in 2015. Secondly, generally stronger EM currencies against the US dollar made the MSCI Emerging Markets Index appreciate even further in US dollar terms.
However, after the US election and despite an exponential rise in the Baltic Dry Index, the ratio of SPY over EEM skyrocketed due to two main forces since the US shares were overpowered by the Trumpflation trade. From this point onwards, the negative correlation between the Baltic Dry Index and the ratio of SPY over EEM broke down completely. When the Baltic Dry Index reversed course and turned to the downside, in late 2016, the SPY/EEM ratio turned down as well. The ratio of SPY over EEM kept falling, since US equities and the US dollar lost the buying support they initially got from the Trumpflation trade. The initial investor optimism about a meaningful fiscal stimulus, coupled with rate normalization, faded out allowing the emerging market currencies and shares to outperform. This made the SPY/EEM ratio to lose half of its post US election gains in just about a month.
Moreover, in the last couple of weeks, the Baltic Dry Index broke its upward trend line and triggered a strong bearish technical signal, reflecting some negative shift in global demand for dry commodities shipping. This bearish signal of the Baltic Dry Index could reflect a downturn in EM's demand for natural resources to be used as inputs in their factory lines. Should this prove to be the case, the acceleration of the EM business cycle, especially in Asia, will end and an economic downfall will drag both the local equity markets as well as currencies down.
If, on the other hand, the drop in the BDI is a mere reflection of excessive inventories of various industrial commodities amassed in EM economies, then the implementation of a pro-growth fiscal policy mix by the US, China, the UK and possibly, other G10 economies, will make US equities the locomotives of global risk assets again.
Apart from the dry shipping industry jitters, of course, the dynamics of base industrial commodities remain positive. The LME index, a gauge of the most important non-ferrous metals, i.e. copper, aluminum, lead, zinc, tin, and nickel, trades close to a one and a half year high, despite the fact that the Trumpflation trade faded out. Other pro-growth assets like the Aussie dollar are getting some decent bids as well. The reflation dynamics are also evident in the emerging Asian bond markets, where the long-term sovereign yields keep their uptrend.
As a consequence, there are two basic scenarios going forward. Either the BDI signal is the first actual crack in the global reflationary scenario with the rest of the commodities and bond markets to follow suit, or it is a signal of a temporary pause due to fears about erratic policy moves of Trump's administration with global repercussions. In either case, EM equities will be hit harder than developed market equities since the former are in a very critical pivotal point from a macro point of view.
Emerging Markets On A Pivotal Point
Some of the biggest EM economies, like China (NYSEARCA:FXI) and India (BATS:INDA), are still in a process of rebalancing their economies albeit based on a different growth model. The first tries to balance out its internal model away from extreme reliance on exports. This necessitated the excessive use of cheap foreign funding, mainly USD-denominated. The second one aspires to gradually take China's seat as the biggest producer of trade surpluses which could finance debtor nations' deficits further down the line. However, it faces its own domestic hurdles lately, with the reserve bank of India to refrain from cutting interest rates further amidst an effort to restore faith in the rupee. Others, like Brazil (NYSEARCA:EWZ), face some of their most challenging macroeconomic situations in decades, trying to tide up their public finances amidst a devastating recession.
All of them, though, share a common characteristic; they are greatly depended on foreign direct investments and on local currency stability in order to secure a seamless refinancing of their private sector's outstanding USD-denominated debts. They need an accelerating global economy as well as additional foreign funding of historically low rates in order either to balance out their domestic bubbles or rejuvenate their aggregate demand through private investment.
While most EM economies are not in the dire position they were during the 1997-98 Asian financial crisis, with most of them having turned their trade deficit into surpluses, they do not have the luxury to experience a slowdown of the global economy. Their markets and currencies are moving under the hope that the Great Fiscal Rotation will materialize as planned, and the US, as well as China, will engage in an inclusive fiscal expansion to further push the business cycle upwards.
Should US president Donald Trump make good on some of his pledges like the implementation of an indiscriminate border tax, the reverberations for EM countries could be devastating not only from a trade point of view. If, for example, the border tax is applied to oil imports as well, then trillions of petrodollars earned by the major oil exporters to the US would be lost as US refineries would be switching their purchases from imported to domestically produced oil. This would have, as a result, the skyrocketing of the US dollar, freezing any USD funding towards EM economies. If, on the other hand, Trump manages to deliver his pro-growth policy pledges without imposing any major disruption to global trade, a second and fierce up-leg in domestic bond yields as well as share prices will materialize. This will most certainly drive US equities faster to the upside than their EM counterparts. Investors in EM equities, however, seem to be expecting a more benign global environment for their holdings than what the current setup suggests.
Investors Too Complacent About EMs
While investors are expecting higher volatility in EM rather than in US equity markets, they nevertheless see the difference between the two markets to be the closest in the last 13 months. This becomes evident by looking at the respective implied volatility indices, i.e. option market-based gauges of expected volatility of the underlying prices over the following 30 days. More specifically, the difference between the CBOE Emerging Markets ETF Volatility Index and the VIX index hovers around 6%, its lowest level in a year. This means that even though option traders expect the volatility of EEM to be about 50% higher than the volatility of SPY, this is the closest this gap has been over a long period of time. As recently as in late December 2016, the implied volatility of EM shares was almost 80% greater than that of S&P 500, just about when the ratio of US to EM shares began its downward reversal. Back in late December, investors were convinced that EM equities and their currencies were destined to suffer much more than their US peers. Currently, investors seem much more convinced that this will be increasingly less the case. However, now, it might be the time to turn towards US shares again.
While US equities have priced in so far an almost perfect macro environment, boosted by expectations on deregulation in many sectors and a pro-growth policy backdrop, EM equities seem most certain to underperform on a US dollar basis. The balance of risks leans more towards the EM side contrary to popular fear about the overvalued US asset prices. Global financial links evident in the huge US dollar carry trade in these economies make things much more complicated in the event of a new US rates rally or a downturn of the global business cycle. As the old saying goes, the devil is in the details.
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Additional disclosure: The views expressed in this article are solely those of the author, provided for informative purposes only and in no case constitute investment advice.