On Thursday, There Was Good News

by: The Heisenberg

There were two pieces of good news on Thursday when it comes to helping risk assets navigate a challenging environment.

In the U.S., CPI missed, pushing the dollar lower and allaying fears that the Fed will be inclined to lean ever more hawkish in the face of rising price pressures.

In EM, Turkey delivered a reasonably convincing broadside against lira weakness and runaway inflation, hiking rates more than the market anticipated.

These points might seem trivial, but they most assuredly are not.

I know it might not seem like that big of a deal, and it would be a mistake to read too much into a single economic data point, but if you're long U.S. equities (SPY) or risk assets of any kind, you should take comfort in the August CPI miss.

For weeks, analysts and market commentators have pounded the table on the idea that going forward, a weaker dollar (UUP) will be the key for risk sentiment. Until August, U.S. equities remained largely immune to the turmoil in emerging market stocks (EEM) and FX and also to bear markets in certain sectors of the European market, including financials and autos.

The divergence is astounding. The following YTD chart shows the decoupling between the S&P (yellow, on top) and the MSCI Asia Pac index (light blue), the MSCI Emerging Markets index (red), European autos (purple), European banks (green), and the Shanghai Composite (yellow, on bottom):

(Source: Heisenberg)

The proximate cause of that divergence is the policy mix in the U.S. Tax cuts and fiscal stimulus catalyzed a buyback bonanza, bolstered corporate bottom lines and buoyed the U.S. economy, while the administration's trade policy dented the outlook for global growth. Meanwhile, U.S. fiscal policy and protectionism have served to support the dollar by making the Fed more concerned than they otherwise might be about an inflation overshoot. The stronger the dollar, the more pressure on emerging markets, especially those who have borrowed heavily in foreign currency and rely on external funding.

Going forward, the consensus is that the divergence has to resolve itself either by the rest of the world catching up to the U.S. or by U.S. stocks catching down to the rest of the world. I wrote about this extensively for this platform in: "Paradox: U.S. Stocks Need A Break From 'America First'".

A benign outcome would be a rally in EM catalyzed by a weaker dollar. Do note that dollar weakness could result from three things: A dovish Fed, a cooling in the U.S. economy and/or a de-escalation on the trade front. Those are not mutually exclusive and indeed, they are inextricably bound up with one another when it comes to how they affect the Fed's decision calculus and thereby the greenback.

In mid-August, the combination of Trump's Fed criticism, China's efforts to put the brakes on yuan (CYB) depreciation and an ostensibly dovish speech from Jerome Powell in Jackson Hole delivered the dollar reprieve risk assets needed. Since then, though, the greenback has regained its footing on the back of a string of upbeat economic data (e.g., ISM, small business sentiment, August payrolls) and renewed trade frictions with China. Positioning remains extremely stretched (on the long side):

(Source: Bloomberg)

Meanwhile, the Argentine peso, the Turkish lira, the Indonesian rupiah, the Brazilian real, and the South African rand came under renewed pressure, reigniting fears about an EM meltdown. Have a look at how EM FX fared from late August through the first few days of September (this captures the meltdown in the peso and news that South Africa fell into a recession for the first time since 2009):

(Source: Bloomberg)

When the August jobs report (released last Friday) showed average hourly earnings rising at the swiftest annual pace since 2009 in the U.S., some worried that it had the potential to start tipping dominoes, especially considering that just hours later, the President suggested he may apply tariffs to an additional $267 billion in Chinese goods after the prospective next round of duties on $200 billion in imports. Both the AHE print and the threat of the U.S. taxing everything America imports from China raised fresh concerns about more dollar strength tied to the expected read-through for inflation and thereby the Fed.

That's why Thursday's CPI print was so critical. Had it beat, it would have reinforced the notion that inflationary pressures are building just as the trade war with China is set to enter the next phase when consumer goods will get hit, driving up prices. Worse still, when you netted out the July CPI print (2.9% YoY, headline) from last week's AHE print (unrounded), you still ended up with negative annual wage growth, which means that any uptick on headline inflation in August would have driven that figure even further into negative territory.

So, it came as a huge relief for markets on Thursday when both the headline and the core CPI prints missed on the downside, with the former ticking back down to 2.7% (YoY) and the latter decelerating to 2.2% annually. Here are the charts:

(Source: Bloomberg)

That should help to allay fears about an imminent (and possibly sustainable) inflation overshoot. The reaction in the dollar was immediate:

(Source: Bloomberg)

As was the knee-jerk lower in 10Y yields:

(Source: Bloomberg)

As for stocks, well, they got a bump on the print too. Here's S&P futures, and do note the other annotation about Turkey:

(Source: Heisenberg)

On Thursday morning, the Turkish central bank delivered a larger-than-expected hike to the policy rate, removing a key concern for emerging markets. Those who want the whole backstory on just why this is so important can read the details here, but for our purposes, suffice to say that there were questions about whether the central bank would again bow to political pressure to avoid hiking. The tension was ratcheted up just hours ahead of the decision when Turkish President Recep Tayyip Erdogan again called for lower rates.

Had the central bank remained on hold after promising last week to act in the interest of arresting soaring inflation (see chart below), the lira likely would have collapsed.

(Source: Bloomberg)

Instead, the central bank hiked, and while I do not believe for a second that Erdogan will countenance much in the way of further policy tightening, for today, the CBT won the battle, as the lira surged:

(Source: Heisenberg)

Now, go back up and look at that EM FX bar chart. Then have a look at a month-to-date version of the same visual that includes today's lira rally, and you can see why this is a big deal for EM:

(Source: Bloomberg)

To be clear, Turkey is by no means out of the woods, but this helps. Erdogan certainly hasn't ceded control of the central bank, which is anything but independent. What today's move does signal, however, is that he's acquiesced to economic reality, if for no other reason than expediency and to buy time.

Want an example of why this matters outside of EM? Look no further than the above-mentioned European banks index, which popped higher on the news.

(Source: Bloomberg)

All of the above is critical to the narrative. From here, risk assets need a weaker dollar and proactive emerging market policymakers, especially in locales like Turkey where central bank independence is in question.

The less pressure there is on the Fed to raise rates, the easier it will be for the dollar to stay well-behaved, where that simply means the greenback not moving aggressively higher to the detriment of ex-U.S. assets. As noted, any further pressure on EM has the potential to boomerang back to Wall Street. That's why you need days like Thursday when the dollar gets an excuse to take a break. It also helped that the euro (FXE) rallied hard following Mario Draghi's press conference.

So, take comfort in the CPI miss and also in knowing that for the time being, some semblance of sanity has been restored to Turkish monetary policy.

Now, hold your breath for the next trade escalation.

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.