With global economic conditions continuing to weaken, there is little chance for an emerging-market rebound, reports Landon Whaley.
Trading emerging markets this year has felt like trying to catch a chicken. I certainly was guilty of taking a shot on the long side earlier this year when emerging market equities ripped higher in conjunction with accelerating data points in a few select economies. Luckily, we realigned our view with the prevailing Winter Fundamental Gravity and have been successfully trading the short side of South Korean and South African equities ever since.
When markets get beaten down for as long as emerging market equities have been, our humanness kicks in, and we want to bargain shop. The truth is, there are few macro trades better than buying cheap assets that are getting ready to be expensive because of a bullish shift in the underlying Fundamental Gravity. That said, the time for buying the weakened emerging market sector is not here, yet. The Fundamental Gravity picture remains crystal clear, confirming that emerging markets are to be avoided (or opportunistically shorted), until further notice.
China’s Economic Weakness
One of the primary drivers of emerging market economies, for better or worse, is China and based on three driving factors.
China’s economic slowdown continued in August as industrial production growth slowed for the seventh month in the last 10, hitting the lowest level in more than 17 years. Retail sales slowed for the third consecutive month and are sitting near an all-time low thanks to the destruction occurring in China’s auto industry. And finally, fixed-asset investment growth slowed for the fourth month in the previous five and is also within spitting distance of an all-time low.
The bottom line is that these three drivers of Chinese economic weakness indicate there’s almost no chance China escapes its growth slowing regime this year.
Other Players
It’s not just the trajectory of China’s economy that is weighing on the recovery potential of emerging economies; the largest economic players are also experiencing slow growth regimes: United States (Winter Fundamental Gravity), Eurozone (Winter), Japan (Fall), Germany (Winter), United Kingdom (Winter), Australia (Fall). If these economies, which represent more than 60% of the global economy, are in slowdown mode, emerging markets 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 Emerging Market Index responded to this strong dollar regime by losing 7.0% and experiencing a massive 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 40.6% with just a 12.3% maximum drawdown.
The greenback has been strengthening since that mid-February 2018 bottom, and as of Friday’s close, emerging market equities have declined 13.5% and experienced a 23.8% peak-to-trough drawdown.
Don’t misunderstand, 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 emerging markets 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 larger economies as well; someone has to buy their production.
Second, we need to see a materially weaker U.S. dollar that is making a series of lower highs, rather than higher lows. Based on our proprietary models, a downtrend in the dollar is likely to begin in late October or early November.
Until these two macro developments occur, we will remain on the emerging-market sidelines with any long positions, channeling our inner Axel Rose, and showing a little patience.
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