Drivers Behind EM / US Stock Divergence are No Joke
- US stocks seem at little risk of contagion from EM counterparts in the short term.
- Evidence suggests that the divergence is far from coming to a head in EM FX and stock issues.
- Domestically, US stocks are likely daring the Fed to tighten past September given the EM situation.
The USD strength caused by various factors is dragging the EM indices into the ground for a simple reason. Those countries dependent on trade and high velocity of money to pay their USD-based debts are suffering at their own carelessness.
A Friendly Word from The Credit Strategist to Stock Holders
Before we get into our own analysis, we thought it appropriate to circle back to our friend and Opportunist Trader Community Member who has a knack for being colorful and right.
On promises of anonymity, he shared his thoughts. "Bon Scott," as he prefers to be called, is a Wall Street Executive at one of the largest real estate development firms on the east coast. He is outspoken and sees things through the prism of real estate development and libertarian views. Here are the questions asked and his responses in quotes.
If the EM Fx issue were resolved overnight, and by whatever means you think it could be;
1) Do you think US stocks go up down or sideways?
2) Do you think the USD would weaken as a cause of the EM equity market pressure relief?
Given a "fixing" of the current EM crisis:
1) Do you think EM would be a short term arb long vs. US stocks?
2) Do you think US stocks would receive some inflows from US bonds in a domestic rotation?
3) Do you view the QT issue as the major driver of this exacerbated by the trade wars, or do you think the trade wars themselves are mostly the issue?
A) It's all QT.
Assuming the crisis continues, do you think US stocks lose their safer haven status:
1) until the problem hits the Euro (perhaps Italy driven)
A) No, fiat is disintegrating all over the place.
2) until the problem actually drives US stocks lower?
A) QT will eventually corral the stock market, probably cause a leveraged loan, junk bond crisis. Risk is mispriced in corporates. But I don't see a repeat 2008 collapse anytime soon, the pressures supporting it are too great... real estate fundamentals are solid, lenders are bullish, oil looks pretty good, the economy is doing fine.
3) they are not affected much at all despite external issues
A) External factors will continue to support US stocks, but I doubt it'll be enough to stave off a correction.
4) some other driver.
A) DJT... He's the greatest Cheerleader in Chief since Reagan. He continues to spend, spend, spend. He's like… F@$k it. And if I put an extra trillion a year on your credit card, I'm sure you could show us a good time. Developers develop.
Don't underestimate the impact his rhetoric has had, is having, and will continue to have... C-suite execs are super-bullish right now, we have build to suit requests out the wahoo. They're responding to Trump, deregulation, new trade deals. In a fiat world it's all a confidence game anyhow.
There you have it.
The Wall street exec and OT Member who predicted Trumps presidency in 2015, accused Trump of spending like a drunken sailor, and who unabashedly believes if Trump were impeached there would be a million man march on DC - and they would be armed - has spoken.
QT Vacuums Up EM Liquidity
First, the US QT is an unwind of excess USD globally, not just domestically. This decrease in USD float also increases the demand for the remaining USD as trade instruments. Debts still have to be paid in USD. An EM country that sells oil and is paid in local currency must then convert that to USD to in turn pay its dollar-denominated debt.
And if its own currency reserves are already depleted, that EM must go into the market and liquidate other assets to get USD, or face domestic inflation as it debases its currency to match the market exchange rate. Basically, their currency suffers from a small indebted float dependent on cash flow to make ends meet. They are dependent on trade either directly or as a one-off from those countries locked in active trade wars. Enter US and China.
US China Trade War
Second is the US China Trade War. While this is bad for both countries, it is worse for ancillary countries dependent on trade between these 2 leviathans to do their own trade. This is one reason that a Mexican deal with the US on trade is appealing for our southern neighbor. It is a hedge against the crisis brewing to their own southern border. It locks in a partner - not unlike how Russia and China have made major inroads with the Saudis for the last 10 years.
China-US Trade War? EM Must Chose its Partner
And to be clear, China has been cutting deals with ARG for years to give it USD in exchange for its soy crop. This is now in jeopardy, as domestic forces may restrict export of ARG crops again. This is first-hand knowledge from dealing with trade nationals in ARG since 2007. Farmers run the economy there. And it could get worse if ARG farmers decide to stop producing because they are denied free market prices.
The same goes for Trinidad's oil, Africa's natural resources and other countries short USD and long materials. China and Russia have been offloading risk not just by buying gold and other metals, they have been planting seeds of hegemony in whole countries the same way.
Now, we see in ARG a situation that demands domestic priority over international trade. Watch closely as ARG either takes the IMF deal, gets help from China, gets annexed by Mexico in a NAFTA tag-along, or collapses upon itself.
Remember, a country in strife can debase its currency first. But in the end, it must wage war. If it does not have a military to wage war externally (like ARG did in past invasions of the Falklands), then the war will likely be civil. The same goes for Turkey, which has the bomb and has both a military and a dissident civilian population.
The trade war between China and the US forces many countries to resolve the issue of who is more important to them in trade. Geographic lines will increasingly be drawn. The US, Mexico and Canada on one side; with China, Russia and SA on the other. It is Europe that will be the football, we feel. They need Saudi oil and Russian gas, but need our military and our USD for protection.
Turkey: Least Needed, Most Risky
Third is the red herring that is Turkey. The US is not very trade-dependent on Turkey, and true to Trump's MO, he will press as he can to get them to capitulate. Whether this results in an IMF rescue or a Middle East financing we do not know, but Erdogan has little choice now except to open his books to outside help or to cut a deal with a less invasive friend like Russia perhaps. Turkey is a conduit for oil transport, and that makes it important. It has an army, and that makes it a wild card. It rants about the US, but owes more in debt to us than most EM countries. We think this will be solved regionally. When we do not know, but actions will likely drive countries like Turkey into the arms of China and Russia
We all know what has been driving EM currencies and equities lower since May of this year: the stronger USD. Here is a monthly graph of SPY/ EM spread for the technicians out there. It does not look good.
Emerging Markets Look Bad and Getting Worse
And here is a graph of what is arguably one of the most stable EM currencies versus the USD during that same time: the BRL/ USD pair. Not as bad as the EM FX market as a whole, but certainly on the edge of being contaminated by its co-dependent neighbor, Argentina.
USD Strength is the Driver of Emerging Market Weakness
Here's the thing, while the USD strength has been the surface driver of these moves in EM markets, what has been the driver of the USD? For us, it is good old fashioned fundamentals associated with debt service in EM land. And frankly, it may get a whole lot worse before it gets better.
A Weak USD Will Not Save EM Now
You would think that if the USD backed off, that would alleviate some of their problems. Apparently, that is not the case. Note the lack of "bounce" in EM when the USD did slide 2 weeks ago.
The USD slide from above 96 didn't seem to do much to stem the sell-off in the JPM EM index and was no help at all outside of a brief dead cat bounce for the two currencies bearing the most scrutiny now.
That is where you'd think the story ends. Wouldn't an easing of USD strength solve the problem, kick the can down the road, live to play another day for the EM? No. That cat is out of the bag, has died, bounced and is on its way lower. The charts above tell us that.
This has gone from a liquidity issue to a solvency issue.That means a look at EM debt outstanding is in order.
The USD is Not the Cause, It is the Catalyst
Turns out the FX and equity markets, in our opinion, are discounting not just a short-term squeeze in USD availability but raising awareness of a much bigger fiscal problem in those countries that gobbled up USD during QE and increased their debt. Monetary policy will not cure EM fiscal ailments now that their debt has been put in the spotlight as depicted above. When the USD weakened a couple weeks ago, it did little to stem the ongoing EM bloodbath. That is when we asked ourselves, "WTF?" And the answer was the USD was a catalyst for the bigger problem depicted below... Debt.
EM Problems Just Getting Started
EM debt relative to their FX reserves juxtaposed with EM debt coming due makes Turkey the biggest problem.
All indicators point to this as the beginning, not the end, of the problem. And we feel that it is part and parcel of the US economic warfare plan to make it patently obvious how dependent the world is on its currency as a reserve base. While this may divide those EM indebted to us, it most certainly will protect the USD status a bit longer in the countries that "choose US." Enter the IMF.
All your Stuff Belong to US - IMF
The IMF's draconian terms to ARG last week, according to which they will loan money provided none of that loan is used to prop up their own currency, speaks volumes. The question is, how much must ARG squeal about the IMF terms before the US, China or some other country comes to their rescue? This is playing out similarly in Turkey, where Germany has made overtures to help in lieu of the IMF. The IMF will get the ball rolling as it always does. From there, we will see who the real stalking horse is in ARG and Turkey. Lest we forget, here is the IMF's Lagarde in her own words:
As the IMF ARG deal goes, this says it best:
"If you neglect to raise rates and shun the IMF, your currency drops 43%. If you hike rates to 60% and get $50bn from the IMF, your currency loses 52%" Simon Cox (@s1moncox)
Do we think that Erdogan will take an IMF offer? This is unlikely, but the IMF's persistence will drive Turkey into the arms of another country that has FX reserves to loan it. Perhaps Germany, Russia or a Saudi country dependent on Turkish pipelines for oil transport.
But we do see China making more plays towards solidifying its ties in LATAM, Trinidad and Africa for necessary trade that also helps them unload USD for oil, soy and minerals, while helping them enlarge their UN voting block. This is verified and something we've been watching closely for years.
FWIW - Goldman Sachs Is Bearish EM
Take the chart above for what it is worth - be thou muppet or trader?
What About US Stocks?
Let's start with volatility. The VIX futures for 60-day delivery is approximately 15.2.0% with stocks at ATHs. When we last saw these levels, the VIX was around 12%. On a relative basis, that is bullish to us. It means that longs are hedging more aggressively, and that they are means better prepared to weather any storm in the next month or so. But that is not a slam dunk, as this graphic shows.
Realized vol is under 10% now, and is a far way off from past periods. You may view this as a contrarian indicator given the jump-off in February, but with implied at 14%, we view it as smart money hedging that potential contrarian indicator.
Stocks in General
Given the lack of easy exit for the EM and the domestic policies of the Fed, we think that despite the doom and gloom predicted by the market necromancing media, the SPY/ EM stock divergence is likely to continue for a while. Further, when it is resolved, we feel it is likely that stocks hold up relatively well to their US bond counterparts.
This is Bullish SPY
Additional tx to:
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