The 'Convergence Trade' Cometh

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by: The Heisenberg
Summary

This week was defined by the fabled "convergence" trade playing out across assets.

The trade tipped in late August by JPMorgan's Marko Kolanovic manifested itself in notable outperformance from EM and European equities.

All the ingredients were there, including a dollar pullback and a concurrent commodities rally.

Now, the fate of the world's most popular market narrative hangs in the balance with the Fed on deck.

This was it: The week of the convergence trade.

Back on August 22, in "Marko Kolanovic's Risk-On Call And Why Bulls Should Hope For A Weaker Dollar", I highlighted what JPMorgan dubbed an "unprecedented" divergence between U.S. stocks and the rest of the world.

The overarching point was that going forward, a weaker greenback (UUP) would be key for U.S. equity bulls. In my next two posts for this platform, I reiterated the same narrative. One of those two followup posts was called "Paradox: U.S. Stocks Need A Break From 'America First'". Fast forward one month to Thursday, and Bloomberg published an article that carried the following headline: "World Markets Are Ready for Comeback as ’America First’ Seen Fading". Sound familiar?

This is when I get to remind folks that when I suggest a shift in the cross-asset narrative is imminent, I mean it. Believe it or not, I don't just write to hear myself talk. My goal on this platform is to give the wider investing community a window into what traders and analysts are saying on a daily basis. That's part and parcel of a broader effort on my part to try and keep folks ahead of the curve.

In any event, the message from the posts linked above was that August marked a tipping point beyond which U.S. stocks would no longer be immune to turmoil in, for instance, emerging market (hereafter "EM") assets.

In a note dated August 21 (the note referenced in the title of the first linked post above), JPMorgan's Marko Kolanovic wrote the following:

The recent divergence in the performance of US Equities vs. the rest of the world is unprecedented in history. There are two likely ways a convergence can play out: “Risk on, USD down” outcome with EM and value assets staging a rally and USD selling off, while US stocks continue going higher (but lagging). Alternatively, we could see a “Risk off, USD up” convergence, with US markets selling off and catching up with the poor performance of Europe and EM assets.

In the immediate aftermath of that call, the dollar took a breather thanks to Donald Trump's Fed criticism, China's efforts to put the brakes on the yuan (CYB) slide and a speech from Jerome Powell at Jackson Hole that was (rightly or wrongly) construed as dovish. Shortly thereafter, dollar strength resumed and EM faltered anew, but this week, the tide turned decisively. I documented the narrative shift extensively in a Thursday post for this platform and I have of course covered it in real time on my own site all week.

Although the dollar rose on Friday, it fell for the week, and the steep decline on Thursday was key. Here's a five-day look at the Bloomberg dollar index:

(Bloomberg)

Commodities, in turn, got a much needed reprieve, rallying sharply amid the dollar's stumbles, gains in crude and copper and stimulus chatter out of China:

(Bloomberg)

Obviously, a weaker dollar and surging commodities are bullish for EM and thus play right into the convergence theme. Let's take a look at how the actual convergence trade played out.

Broadly, EM stocks had a stellar week. In relative terms, this was the best week for the iShares MSCI Emerging Markets ETF (EEM) versus the SPDR S&P 500 Trust ETF (SPY) of the year:

(Heisenberg)

As far as EM FX goes, this was the best week for the MSCI gauge since February:

(Heisenberg)

Two of the most egregious offenders when it comes to EM FX turmoil (the Argentine peso and the South African rand) led gains this week, in a testament to the abrupt about-face in sentiment towards developing economy assets:

(Bloomberg)

Meanwhile, the iShares JPMorgan EM Local Government Bond UCITS ETF (that would be the largest EM local currency debt ETF) took in the most money in more than a year on Tuesday:

(Bloomberg)

Oh, and remember how, on Tuesday evening, I suggested that it might not be a terrible time to bet on a rebound in Chinese equities considering the vaunted "National Team" is inclined to defend the 2016 lows on the Shanghai Composite? Well, this ended up being the best week for mainland shares since May of 2016 (the red shaded portion in the following visual is just a reminder that China is still in a bear market):

(Heisenberg)

This was also the best week since 2016 for the Shanghai Composite in relative terms (i.e., versus the S&P):

(Heisenberg)

So, that's your convergence trade in EM.

What about Europe? Spoiler alert: It was the same story. The Stoxx 600 Basic Resources Index, for instance, surged a ridiculous 7.8% on the week, the best weekly gain since March of 2017:

(Heisenberg)

The trade-sensitive Stoxx 600 Autos and Parts index had its best week since January and has now posted consecutive weekly advances. Broadly, this was the best week for European equities (FEZ) since March. The Stoxx 50 outperformed the S&P by the widest margin since April:

(Heisenberg)

You get the idea. The convergence trade is here and it's playing out in fairly dramatic fashion. The question now is whether it's too late to ride the wave or whether this has further to run.

To be clear, a quick look a the simplest of all possible charts suggests we're nowhere near a resolution. The following visual is just the YTD performance of the S&P plotted with the Stoxx 50, the MSCI EM equities index and the Shanghai Composite:

(Heisenberg)

If you're wondering what the above-mentioned Marko Kolanovic thinks, he was out with a new asset allocation piece this week. Those interested in the details can read more here, but for our purposes, the bottom line is that he's sticking with a pro-risk allocation and also with the convergence trade. Here's an excerpt:

US Q2 earnings were very strong (+25% y/y) with the highest number of beats in nearly 10 years. Europe and Japan earnings were above-average, but less impressive. We expect the strength of US earnings to continue. Looking further out, earnings growth should moderate to ~10% as benefits from tax reform wear off. The record amount of corporate buybacks should continue to support US earnings and hence equities. We thus remain OW US equities, but use the current strength to trim down the US and start to build larger exposure in EM equities which are trading at distressed levels.

Take note: Next week will be interesting. Trump's new tariffs on China go into effect on Monday and with them, Beijing's retaliatory measures. Goldman now puts the odds of the administration effectively using that retaliation as an excuse to justify slapping tariffs on another $267 billion in Chinese goods (and thus taxing everything the U.S imports from China) at 60% by year-end.

But the bigger test will come from the Fed, the dots, and Jerome Powell's communication at the September Fed meeting. The fate of the convergence narrative will likely be decided one way or another next week.

Trade accordingly based on your inclination to believe Powell can effectively massage the message (if you will).

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.