Our latest thoughts from my colleague Larry Brainard re the EM recent washout. Recent EM market weakness is not a broader retrenchment in EM assets, but risks of contagion from the Argentine and Turkish crises are growing; US-China trade conflicts are becoming increasingly strained.
The good news is that recent weakness in EM markets appears to be a market correction, not the beginning of a broader retrenchment in EM assets. What is different in the current environment is that the global economy has been pumped full of liquidity via QE by developed country central banks – US$9tr and counting. This has created cycles that are very much driven, both up and down, by excess liquidity, i.e. factors such as positioning and momentum. Changes in either economic fundamentals or investors’ perception of those fundamentals trigger initial market movements, which are then amplified by market technical factors, ultimately leading to market moves well beyond what, based on historical trends, might have been expected. The persistence of excess and still growing global liquidity means EM markets will increasingly be buffeted by more frequent and violent market behaviour than they were in the past.
The catalyst for recent EM volatility was the reversal in the fortunes of the dollar. As of yesterday, the weighted US dollar index (DXY) had risen 5.3% since end-March, driven by market perceptions of developing economic weakness in the Euro area during Q1/18. These moves had a significant knock-on effect on EM markets because a stronger dollar is broadly negative for EM currencies and hence for the economic prospects of those countries.
We believe these developments have now largely run their course. The Q1/18 soft patch in Euro area growth appears over: growth is plateauing but remains relatively strong. Meanwhile, the US economy is reflecting slow rises in prices and interest rates and accelerating capex – factors that point to a traditional business cycle. Following large-scale outflows from EM markets recently, positioning in EM assets has been significantly lightened. Many EM markets are now likely to recover some of the ground they lost since January. For this reason, investment performance remains vulnerable to the liquidity-related volatility noted above.
The bad news is that the turmoil faced by Argentina and Turkey over the past month raises concerns that other EMs will face rough market conditions ahead. Investors have been concerned for some time that Argentina’s gradualist reforms did not address the risks of the country’s high dependence on external financing and continuing high inflation and fiscal deficits. The volatility in Turkish markets, meanwhile, reflected concerns that the economy was overheating and pushing up inflation and the country’s sizeable current account deficit. In both cases, investors judged that policymakers were failing to address emerging risks.
The last 10 years of QE has created a “yield-seeking” mentality in markets that inevitably forced investment flows into EMs but without pricing the risks associated with an eventual reversal of QE. For now, global liquidity remains abundant; but at the margin, the Fed has stepped up its pace of exiting QE, while the ECB is easing the aggregate size of its QE actions. In assessing the risks that lie ahead, it is relevant to recognize that markets will react based on expectations of tighter liquidity well ahead of when it does, in fact, occur – if, of course, it ever does.
Thus, there are reasons to be concerned that spreading contagion could hit other EMs. The economic turmoil evident in Argentina and Turkey may be a harbinger of what is in store for other EMs, such as Brazil. It is simply that individual countries could be punished by markets because their economic situations are not considered viable in a scenario of reduced global liquidity. Further, last month’s developments highlight that such a scenario is possible – likely, even – without global liquidity conditions having yet changed to any significant extent.
What is ugly is that US-China economic relations are reverting to the mutual suspicion and hostility that was evident prior to the 17-18 May Washington trade talks. Apparently realizing that he had been outmanoeuvred by China in those talks, Trump changed his demeanour early last week, playing down his earlier enthusiasm: he tweeted that the final deal “could be much different” from what came out over the weekend. Earlier, a number of Washington trade hawks and legislators slammed the deal as being a capitulation. A similar “get tough on China” sentiment was evident on Capitol Hill as both Republicans and Democrats vowed to enact legislation this year to prevent sanctions relief to the Chinese electronics firm ZTE and to toughen restrictions on Chinese investment – and, potentially, on investments of US tech firms in China. Last Thursday Trump announced that he had cancelled the planned June summit with North Korea leader Kim Jong-un only to send signals subsequently the meeting may still take place after all. Meanwhile he renewed his threats to impose tariffs on $50bn in Chinese imports, reflecting a hardening of his stance on China trade.
Faced with such developments China’s leaders will likely react by radically changing their international economic development strategy to diversify aggressively via the development of better commercial relations with non-US high-tech firms, particularly in Asia. A parallel development already under way is the significantly stepped-up investment programme of domestic R&D in high-tech sectors. For their part, Chinese firms will seek to eliminate the “made in China” risk by moving more of their production offshore – most likely within Southeast Asia.
President Trump’s assault on the post-war trading environment is accelerating the emergence of new international trading blocs. China now has no choice but to build an East and Southeast Asian trading bloc so that it can reduce its dependence on the US. Such a trading bloc would involve the development of complex supply chains that facilitate cost savings via specialization and just-in-time deliveries of components along with real-time control of logistics. An East and Southeast Asian trading bloc centred on China would be economically viable, and political support appears likely. Ironically, Trump has just given Xi Jinping a compelling reason to support the building of such a trade bloc.
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