'Herd Behavior'

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by: The Heisenberg
Summary

The situation in emerging markets worsened materially this week and can now quite fairly be described as "acute".

On Wednesday, traders were tossing around the "throwing babies out with the bath water" metaphor to describe the price action.

Meanwhile, U.S. tech shares got a rude awakening as the regulatory risk bogeyman reared its ugly head.

Here's everything you could ever want to know, complete with all manner of visuals and potentially actionable information.

Chinese officials are fond of advising market participants of all stripes to avoid irrational decision making based on an overriding tendency to follow one-way price action. Beijing has a subtly derisive nickname for that tendency: "Herd behavior".

Most recently, the PBoC rolled out the "herd behavior" warning on August 7, in the second of what would ultimately be a four-step approach to putting the brakes on yuan (CYB) depreciation.

Of course, when China warns traders to think twice about following the crowd and thereby perpetuating wrong-way momentum in the yuan or Chinese equities, they aren't simply exercising a bit of benign paternalism in an effort to save folks from making ill-advised decisions. Rather, when you start hearing Chinese officials warning about "herd behavior", it usually means things are headed in the "wrong" direction and warnings from officials in many cases presage draconian crackdowns aimed at restoring stability. So, it's a warning in the most literal sense. Something like this: "Correct this behavior now, or we'll correct it for you in short order."

That approach has met with varying degrees of success since the meltdown in the Chinese equity market three years ago and the subsequent devaluation of the yuan in August of 2015. Sometimes, traders heed the call to stop selling and other times they don't. In the latter case, China has been known to go as far as they need to in order to arrest what they deem to be irrational price action. When the margin-fueled Chinese equity bubble burst in 2015, for instance, China halted 72% of the market with trading in $2.6 trillion worth of shares representing more than 1,300 companies suspended. In the case of the yuan, the PBoC has a veritable armory of weapons to deploy when depreciation pressure builds, including the laughably opaque "counter-cyclical adjustment factor", which was reinstated this month in the final step of the four-pronged approach to shoring up the currency mentioned above.

Of course, China is unique in both its capacity and, more importantly, its willingness to dictate market outcomes by overnight decree. Other emerging markets (hereafter "EM") have neither the clout nor the desire to go that route when the going gets tough, which means when the "herd behavior" starts, there's not much policymakers can do to stop it.

Well, the first three days of this week were defined by "herd behavior" in EM. On Wednesday, as the South African rand dove and Indonesian shares (EIDO) fell the most since November 2016, traders were tossing around the panic adjectives and rolling out the mayhem metaphors. The price action was "indiscriminate" and "babies" were being "thrown out with the bath water", the chatter read. Here's a month-to-date snapshot of the EM FX complex:

(Bloomberg)

If you've been following along this year, you recognize this for what it is: The culmination of a selloff that can be traced directly to the reversal of the dynamics that drove investors down the quality ladder and out the risk curve in the ten years since the crisis. A decade of developed market (hereafter "DM") monetary policy accommodation sent investors on a global hunt for yield, funneling vast sums into risk assets and prompting EMs to borrow heavily in foreign currency. Now, as the Fed tightens and other DM central banks ponder the long road to policy normalization, that dynamic is reversing.

The first dominos to tip were the wobbliest. Turkey and Argentina are special cases and likely would have run into trouble of their own accord, but it's no coincidence that the collapse of the lira and the implosion of the peso have unfolded against a backdrop of Fed tightening and a surging dollar (UUP).

"In this more challenging environment, the fragility of some EM economies – most notably Turkey and Argentina – has been exposed, and the risk that market moves worsen further without decisive policy action remains high in both", Goldman wrote, in a note out Wednesday evening, with the caveat that "economic fundamentals across the majority of EMs are healthier."

While that latter bit about the rest of EM being "healthier" than Turkey and Argentina is true, this is all a symptom of DM policy tightening. Back on May 13, I wrote a post for this platform called "Jerome Powell May Live To Regret These Statements", in which I suggested the Fed chair would ultimately come to lament comments he made at an IMF/SNB event where he told an audience the following:

Monetary stimulus by the Fed and other advanced economies played a relatively limited role in the surge of capital flows to (emerging market economies) in recent years.

There is good reason to think that the normalization of monetary policy in advanced economies should continue to prove manageable for EMEs.

That assessment has not been borne out.

To be sure, it's not all Powell's fault. He and the Fed have been pigeonholed into hawkishness this year by a combination of late-cycle fiscal stimulus in the U.S. and protectionist trade policy, both of which have the potential to be inflationary. Initially, concerns about America's fiscal trajectory and the idea that U.S. trade policy was a weak dollar policy by proxy, kept the greenback from responding to a favorable shift in rate differentials. In April, that all started to change.

As the dollar rose, EM began to crack in earnest and midway through last month, multiple analysts (including JPMorgan's Marko Kolanovic) suggested we had reached a tipping point. In order for the U.S. equity rally to continue, the dollar would have to take a breather. Simply put: The divergence between U.S. stocks (SPY) and the rest of the world had reached unsustainable levels.

Just to put this in perspective for you, the normally positive correlation between the S&P and the MSCI Emerging Markets equity index (EEM) is experiencing a historic decoupling. Have a look at this:

(Bloomberg)

As far as I can tell, that is unprecedented.

EM equities have fallen for six consecutive sessions. Wednesday was the worst day in three weeks or, more to the point, since the bottom fell out for the lira.

(Heisenberg)

It's no mystery why the past several sessions have seen a renewal in EM angst. For one thing, sentiment has soured on Argentina and Turkey again.

Last week, the bottom fell out for Argentine peso after President Mauricio Macri's call for the IMF to accelerate disbursements went awry, prompting an emergency rate hike the next day. The market was spooked and the currency careened past 40.

(Bloomberg)

Meanwhile, the Turkish lira came under renewed pressure as the market again questioned the political will of the central bank in the face of President Erdogan's aversion to rate hikes. On Monday, the latest inflation data out of Turkey underscored the urgency of the situation. The annual inflation rate surged to 17.9% in August from 15.9% in July:

(Bloomberg)

That would have been bad enough on its own, but the real shocker was producer prices, which jumped an astonishing 32%, suggesting that producers and retailers are simply unable to pass along the true impact of the currency's slide on to consumers for fear of crushing demand.

(Bloomberg)

Now, Turkey has to hike this month. But again, there is enormous political pressure not to, which means any move by the central bank will likely disappoint the market.

But it's not just spillover from the peso and the lira that's undercutting sentiment in EM again. The dollar has retraced much of its mid-August breather and that, in turn, is piling pressure on the entire EM complex. Here's the Bloomberg dollar index:

(Bloomberg)

Are you curious to know how much that matters for EM? If so, then look no further than the following visual which shows you that the 21-session correlation between the greenback and the EM ETF is the most negative it's been since 2016:

(Bloomberg)

With the dollar back on the rise and sentiment souring anew thanks to Turkey and Argentina, Indonesia and South Africa are next up in the firing line.

Take a look at a chart of the Indonesian rupiah with the policy rate:

(Bloomberg)

See the problem there? Bank Indonesia has hiked 125 bps since May, to no avail. In fact, the rupiah fell to its weakest against the dollar since 1998 this week.

(Bloomberg)

In case it isn't crystal: Rate hikes are not working. Despite tighter policy and all manner of intervention from the central bank, volatility on the currency has soared:

(Bloomberg)

Now, BI will likely have to resort to another out-of-cycle (read: emergency) hike. But that's perilous, because hiking rates risks choking off growth and endangering the stock market. On Wednesday, Indonesian stocks fell nearly 4%, for their worst day since the immediate aftermath of the U.S. election.

(Heisenberg)

Meanwhile, South Africa has fallen into a recession for the first time since 2009:

(Bloomberg)

That marks a rather inauspicious start for Cyril Ramaphosa and represents a fresh blow to the consensus narrative about the fundamentals being generally sound outside of Turkey and Argentina. You'll note from the first chart shown above that the rand is the worst performer in EM FX this month. Implied volatility is now well above levels seen during last month's selloff in the lira.

(Bloomberg)

Are you starting to get the picture? This is precisely what I was warning about in early May (and in several followup posts to the "Regret" piece linked above) when I suggested Jerome Powell would be forced to reassess what Fed tightening will mean for EM by the end of the calendar year.

In the same Wednesday evening note cited above, Goldman weighs in with this:

Following a period of sustained acceleration between 2016Q1 and 2017Q4 – during which our Developed Market Current Activity Indicator rose from +1.4% to +3.5% – DM growth has slowed this year, to 3.0% in the 3 months to July (Exhibit 1). Even at this lower level, DM growth is still tracking above its post-crisis averages (+2.1%). Nevertheless, on a sequential basis, the slowdown in DM activity represents a negative impulse to EM growth. Having eased significantly between late 2016 and early 2018, EM and global financial conditions have tightened materially since February (Exhibit 2). This tightening, which has been triggered by a reappraisal of US rate prospects, has been driven by higher global long-term interest rates and a decline in global equity prices.

Again, the trajectory here is not great and what's needed to turn things around is a weaker dollar and a dovish Fed.

When it comes to playing this in the market, I would refer you back to the correlation charts shown above. I can't tell you which side of the trade to pick, but when it comes to providing readers with actionable information, it's difficult for me to imagine what could possibly be better than two visuals depicting historic extremes in correlations between three easily tradable assets (the dollar, the S&P and a highly liquid EM ETF). One way or another, the extremes shown in those charts will likely mean revert. It's just a matter of what drives the reversion.

Sticking with the "herd behavior" theme, I wanted to briefly touch on what happened to tech in the U.S. on Wednesday. As Facebook's (FB) Sheryl Sandberg and Twitter's (TWTR) Jack Dorsey attended a hearing on Capitol Hill, tech shares crumbled. Specifically, the Nasdaq 100 (NDX) had its worst day relative to the S&P since the late July selloff.

(Heisenberg)

When it comes to where the "herd" is, you'd be hard pressed to find a more crowded trade than the FANG contingent and their ilk. Over the past several weeks, I've documented the extent to which a revival of the "long Growth/Momentum" trade that stumbled following the late July FANG+ correction accompanied the dollar's mid-August breather. That would be the same breather in the greenback that gave EM a fleeting reprieve. Wednesday's tech selloff once again exposed what is perhaps the one chink in the sector's armor: Regulatory risk.

I'm certainly not in the camp that thinks you should sell tech titans based on the proposition that a regulatory overhaul which threatens their business models is imminent. I can make you a laundry list of reasons to sell tech right now, and that isn't one of them. Yes, the regulatory risk is real, but the realization of that risk will be a long time coming.

Still, that doesn't change the fact that traders are a fickle bunch and anytime the regulation issue gets thrust back into the spotlight, these names are vulnerable. When big-cap tech sells off, it dents consensus long Growth (IVW) and Momentum (MTUM) strategies, and that's bad news given that Value (IVE) has yet to prove it's capable of taking the baton in terms of market leadership.

On the market leadership point, have a look at this chart from Goldman:

(Goldman)

It's not so much that you should be worried about tech rolling over because the sector's most recognizable names account for a disproportionate share of the broader market's gains. Rather, you should be worried about tech rolling over because when it comes to the "quality" (if you will) of the post-crisis rally, the earnings contribution for tech is twice that (and then some) of the market ex-Tech. In other words: Tech is where the profits are. Without tech, you've got a market that's far too dependent on multiple expansion.

Coming full circle, the selling in EM has been indiscriminate of late. There's a lot of "herd behavior" going on there and once the herd gets moving in the "wrong" direction, it's difficult to turn things around, especially when the most powerful external driver in the world (the Fed) has so far demonstrated a reluctance to let international developments dictate domestic monetary policy.

As far as the passages on tech go, I don't want to suggest Wednesday marked some kind of turning point for the space. I simply wanted to point out the fact that when it comes to arguably the most crowded trade on the planet, there is one persistent worry, and that worry is regulation. Given how investors and hedge funds have herded into tech, if anything were to go materially wrong there, you could well get a stampede in the opposite direction, although that seems unlikely, at least where regulatory risk would be the catalyst.

What is entirely possible, however, is that the regulatory overhang persists into the U.S midterms as the issue of election meddling continues to make the nightly news. If the trade frictions resurface (and remember, the public comment period on the proposed levies on an additional $200 billion in Chinese goods expires on Thursday) leading to further dollar strength and more pressure on EM while tech is (justifiably or not) hamstrung in its ability to play Atlas, well then that combination could be a real drag from now until November.

Nothing further for now.

Disclosure: I/we 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.