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Episode 5

What emerging markets are saying about growth?

Published on: November 27, 2019 • Duration: 15 minutes

This week we focus on the signals being given by emerging market currencies. The market chatter looks at the potential for the US to escalate trade tensions with Europe. And the whisper looks at what to expect from incoming ECB president Christine Lagarde.

  • [00:00:04] Many risk assets have been pricing in a rebound in global growth over the last couple of months, and yet a number of emerging market currencies, including those that should benefit from global growth, have been incredibly lacklustre and some of them even testing their lows versus the US dollar. Is this bout of reflation, therefore, merely a mirage? That's the big conversation.

    [00:00:33] Since September, we've seen a rebound in bonds and equities, which appear to be pricing for a rebounding growth and shift away from deflation or disinflation towards reflation. Equity markets such as the German DAX, which is heavily influenced by global manufacturing, have been some of the best performers. The Japanese Nikkei 225 gained 16 percent. The European based resources and mining sector gained in excess of 20 percent. And bond yields have also put in some significant reversals. The German 10 year bond yield rallied from around about minus 74 basis points to minus twenty two still negative, but a big move. Also the US 10-year yield rose from the lows of around about one point four percent, up to just shy of 2 percent. And outwardly these are all signs that either people just got too negative on growth earlier in the year or that there were genuine signs of a rebound. But amongst this new found investor optimism, many emerging market currencies versus the US dollar have continued to trade pretty poorly. And these following charts show the US dollar versus emerging market currencies so that a chart where the line is moving to the upside signifies U.S. dollar strength and local currency weakness. Now, for some countries, there are specific domestic tensions that have helped drive their currencies to new lows. The first one and perhaps the most dramatic is the Chilean peso. Now, obviously, there's been a wave of unrest that swept through the country. And although there are also technical factors, these are not sufficient on their own to explain the move. Argentina has been undergoing well-documented economic problems, so there's no surprise that its currency is again testing the extremes. But Brazil, on the other hand, has been a story of economic reform under president Bolsanaro. The local equity market, the Bovespa has been making a series of new highs. And yet the US dollar versus the Brazilian Real is very close to breaking the all time highs. It's not quite there yet, but the risk of a break is very clear. And this is one of the reasons why foreign investors have not had the same excitement from the Brazilian equity market as a local investor. The MSCI Brazil Index, which many global ETF are based off, is priced in US dollars, and because of this it has significantly underperformed the local market. The Mexican peso looks like it's coiling for a break. That's the sort of chart pattern that could go either way. But if we take the lead from the regional peers of South and Central America, then the risks appear to be skewed towards peso weakness. The South African rand has also been in a consolidating pattern over the last 12 months. It's in a pattern which is not dissimilar to the Canadian dollar. Now, that's not an emerging market currency, but along with the Australian dollar, these have also been on the weaker side over the last few months as well. But why should we expect EMFX to perform when the world is pricing for reflation? This can probably be explained by the concept of the US dollar smile and is a sort of a shape of the dollar. What is the smile? Well, the three main regions or areas where this comes from. Firstly, when there's runaway growth in the US, the US can be strong, and the dollar can be strong as long as that growth is focussed within the US. Some of the dollar's strength over the last 18 to 24 months is due to tax changes, initiating a one off fiscal boost for the US. So these are very specific to the US, but those should now be fading. Dollar is often weak when we have a period of synchronized global growth, i.e. a boom or a reflation period, when there is synchronized growth. Investors hunt out better returns in overseas markets than can be found in the US, driving demand for higher beta currencies, which are often found in emerging markets. But rather than this being US dollar weakness, this is actually global strength. Then the third element, this is back to US dollar strength now, is that it can be strong during periods of global weakness or recession. You get a repatriation of capital and a search for safety that helps drive up the demand for dollars. We saw the dollar surge during the great financial crisis, even though the US was at the very epicentre of that meltdown. And a great way of looking at this maybe 2016 where the dollar smile was encapsulated in the action throughout the year. It started off the year with worries about a global meltdown created by the commodity bust - that was dollar strength. It then moved through a period of synchronized global growth after China injected credit and the Fed stepped back from some of the rate hikes. And that was a period of dollar weakness before finishing the year, surging on expectations that Trump's election would boost policies focused on domestic US growth i.e. America first. Now the dollar can potentially be weak if the US is undergoing slow growth. But this really would have to be in isolation without any contagion effects whatsoever. But normally, a drop in U.S. demand, and weakness in the US, has a knock on effect for global markets and doesn't really operate in isolation. And currencies are a relative game. Even if the US economy is getting weaker, is it getting weaker at a faster rate than other economies? Some would argue that today the US economy is doing precisely this, decelerating whilst other economists pick up. But if that's the case, why aren't emerging market currencies doing a lot better? Well, most but not all of the currencies that are on the back foot are in the commodity space. Places like Brazil, Australia, South Africa, Canada. And the biggest player in the commodity space over the last decade in absolute terms and in terms of change has been China. And China appears to be showing no signs of returning to its former infatuation with fixed asset investment and that demand for commodities. China has been redirecting its capital into its own domestic economy to try and patch things up. Producer price inflation in China has once again fallen into negative territory. There is a very high correlation between Chinese PPI and the change in global commodity prices in RMB. China has taken its foot off the gas and demand for raw materials remains sluggish. The commodity currencies such as Brazil, Chile, South Africa, Canada and Australia all reflect that real underlying economic activity that has failed to pick up, or at least the part that was formerly fuelled by China's appetite for growth. So the reflationary winds that have swept through many markets of the world's asset classes would appear to be little more than a reversal of the excessive pessimism that there was in the market earlier this year, fuelled by a recent expectation that the Fed and the ECB are becoming more accommodative. Emerging market currencies are close to breaking down, and if currencies such as the Brazilian real break significantly lower versus the US dollar, then we should probably be on warning that there is a risk to commodities and commodity stocks. And if we see pressure on commodities and commodity stocks, then the chances of the next big move in bond yields will once again be down as the world prices in the fact that China is not coming back to the commodity market.

    [00:07:56] There's been a lot of chatter about trade tariffs, but these have been mainly focussed on those between the US and China. The US trade deficit with Europe has been getting wider and wider over the last decade. It currently stands at around 150 billion dollars per year. As can be seen from this Refinitiv chart, the deficits have been reaching as much as 16 billion per month. But in a potential escalation. U.S. officials were last week considering whether to start a new trade investigation against the European Union. Initially, this could have been seen as a slight short term positive because it would mean that the window for more European auto tariffs is closing. Auto imports into the US wouldn't be subject to further duties in this scenario. But it does open the window to impose a much broader set of restrictions on Europe should the US wish to pursue this new line of inquiry. But why does this matter? Well, apart from the obvious uncertainty creates for global corporates and their supply chains right now, it would impact the green shoots narrative of reflation that has buoyed European and global equity markets. Now some people will say, well, what green shoots? The latest round of preliminary European market PMIs have hardly shifted off their lows. In fact, some of the readings last month were worse than the previous month. The German equity market has been one of the best performing markets in the second half of 2019, outperforming even the mighty S&P 500. And the longer term trend, however, has been one of US outperformance versus broader Europe. But the Euro Stoxx 50 has been going through a period of consolidation versus the S&P 500. So therefore, renewed focus on tariffs on Europe could undermine that. Also, the upswing in equity markets has in many ways got well ahead of the improvement in the underlying data and this can be seen by the divergence between global PMIs and global equity markets. Hope of a resolution and not an escalation had recently been providing risk assets with some impetus. So renewed trade pressure would damage this fragile recovery, which had been born out of an expectation of growth rather than actual growth. And positioning now is much more crowded than it was a couple of weeks ago. And therefore the ability to withstand external shocks and surprises has been reduced. And it's also worth noting that markets are trading much more on political sentiments than off economic fundamentals. So should investors think about hedges? Well, if you are uncertain, then Europe offers some great possibilities. Volatility on the DAX has recently returned towards the low end of the range, as has volatility on the Euro Stoxx. Historically, European markets have tended to have a higher down beta in selloffs than the S&P. What that basically means is in the case of a big sell off, Europe normally underperforms the S&P 500 and that's pretty much the case on all the major selloffs since 2000. And if you are thinking about options, it's worth noting that the big liquid December options expiry takes place on Friday, December 20, so pretty close to the end of the year. So if you are nervous that equity markets are overstretched and that an escalation in trade rhetoric is still one of the biggest concerns, then buying protection on European indices into year end may be the best way to hedge against this potential threat.

    [00:11:31] On Friday, November the 22nd, at the Frankfurt European Banking Congress, Christine Legarde, the new head of the European Central Bank, or ECB, delivered her first speech since taking over from Mario Draghi at the helm. Now Legarde has inherited an economy in which some of the key metrics, such as producer price inflation, has once again started turning negative. Overall, inflation remains below the long term target of 2 percent. Inflation expectations are still anchored near their all time lows, as can be seen in this chart of eurozone five year inflation swaps, five years forward. Expectations matter. Low growth expectations are a disincentive to long term investment. Lagarde has also inherited a fractious ECB committee. The parting shot of outgoing ECB president Mario Draghi was to restart quantitative easing only 11 months after the previous QE program had ended. He also promised to make it open ended until that 2 percent inflation target is hit. Now, that could be many years into the future, with some proclaiming that open ended could be interpreted as infinite QE because Europe will never hit that target. The key, however, was in his final comments as president, where he once again exhorted the eurozone authorities to spend big funded by bond sales. If anyone who thinks Lagarde is going to veer from this route should take a look at the speech that she wrote. She is going to stay true to the monetary path, that Drghi has started, saying that the ECBs accommodation policy stance has been a key driver of domestic demand during the recovery. And that stance remains in place. And Lagarde will enthusiastically take up the challenge for which Draghi has laid the foundations. In fact, further in her speech, she said very clearly monetary policy could achieve its goal faster and with fewer side effects if other policies were supporting growth alongside it. What are those other policies? Well, again, clearly one key element here is euro area fiscal policy. And she finished by quoting Saint Francis of Assisi saying “start by doing what's necessary, then what's possible and suddenly you're doing the impossible”. What does that mean? Well, in simple terms, they're going to continue doing QE. They are going to encourage governments to spend probably by amounts which are way, way in excess of their revenues so that with the help of the ECB, governments can do this in unlimited size in order to kickstart the euro area growth. This is QE for the masses. It is modern monetary theory or MMT. Investors may not like it, but we still have to prepare for it. And rest assured, Europe will not be the only region that tries it.