Chinese economic weakness, falling global growth and a strengthening dollar are putting pressure on emerging markets, writes Landon Whaley.
Trading emerging markets this year has felt like trying to guard Steph Curry. I certainly was guilty of jumping on the head fake when emerging market equities ripped higher to start the year in conjunction with accelerating data points in a few select economies. Markets often front run shifts in the Fundamental Gravity, so it was a reasonable assumption that a few emerging market economies were shifting out of fall and winter into spring and summer. That assumption turned out to be dead wrong, earning emerging market resurgence believers like me a green light
Luckily for us, the emerging market picture has become clear with the recent data deluge, confirming that the emerging market sector is to be avoided, until further notice.
China
One of the primary drivers of emerging market economies, for better or worse, is China. Everyone got bullishly hyped up when China’s March growth data showed improvement across the board for the first time since late 2017. Unfortunately for investors who bought Chinese equities in March on the premise that “the bottom is in,” Chinese equities peaked the first week of April and have since corrected 10.6%.
Remember how markets front run FG shifts?
Last week, China released the April data for the Big 3 (retail sales, industrial production, fixed asset investment), making the April correction in equities crystal clear.
Retail sales fell off a cliff, falling to +7.2%, which is this the lowest retail sales growth since 2004. Industrial production fell from +8.5% in March to +5.4% and has been in a consistent downtrend since May 2018. And finally, fixed asset investment slowed as well, keeping its downtrend intact.
After China released the grisly Big 3, we immediately cut our long Taiwanese equities trade because we know Taiwan won’t be able to sustain its summer Fundamental Gravity as long as China’s slowing growth is weighing them down.
Other Players
It’s not just the trajectory of China’s economy that is weighing on the recovery potential of emerging-market economies; the largest economic players are also experiencing slow growth: United States, Eurozone, Japan, Germany, United Kingdom, France and Brazil. Folks, if these economies, representing more than 60% of the global economy, are in slowdown mode, emerging-market economies and their respective equity markets don’t stand a chance.
Beyond this growth slowing reality, there is another factor delaying an emerging market resurgence, the U.S. dollar.
Dead Presidents
In general terms, weaker growth in international economies means a stronger U.S. dollar. Having an opinion on the direction of the USD is a critical factor in successfully trading emerging-market equities because the relationship between the greenback and emerging markets is strong and historical. As a case study, if we evaluate the last five years, the inverse relationship between the greenback and emerging-market equities is readily apparent.
From May 2014 until March 2015, the U.S. dollar gained a whopping 26.9%. How did the MSCI Emerging Markets index fair over this time? It declined 6.9% cumulatively and experienced a nearly crashworthy drawdown of 17.7%.
From March 2015 to November 2016, the U.S. dollar traded sideways, but at an elevated level averaging a price of $96.51 over that period. The MSCI EM index responded to this strong dollar regime by losing 7.0% and experiencing an elevator shaft-esque drawdown of 34.5%!
The USD then peaked in January 2017 and began a 13-month downtrend that ended in mid-February 2018. During this weak dollar regime, emerging-market equities gained a healthy 40.6% with a maximum drawdown of 12.3%.
The greenback has been strengthening since that mid-February 2018 bottom, and as of Friday’s close, emerging-market equities have declined 15.0% and experienced a 23.8% peak-to-trough drawdown.
Don’t get me twisted; many factors play into how emerging-market equities trade and the dollar isn’t the only catalyst. That said, I’m not aware of any meaningful duration of time when emerging-market equities have been able to maintain upside momentum if the USD hasn’t been either trending lower or trading in a sideways box less than $90.
The Bottom Line
Avoid the emerging market space until we see two critical developments.
First, we need to see a shift into spring and summer Fundamental Gravities across a wide swath of not only emerging-market economies, but the larger, more influential economies as well.
Second, we need to see a materially weaker greenback that is making a series of lower highs, rather than higher lows.
Until these two macro developments occur, we will remain on the sidelines, channeling our inner Axel Rose, and showing a little patience.
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