NY Open: Forex can't find traction
FX markets are a tad choppy but ultimately directionless. Wall Street, however, liked the Turkish lira rally, and the three major US indices opened in positive territory.
Instrument: EEM:arcx, SPY:arcx
Price Target: 10%
Market Price: n/a
For months we have been arguing that emerging market equities should be underweighted driven by a weaker China, currency troubles in several EM countries (with Turkey the most evident), and worsening current accounts across many EM countries. With the developments in emerging markets taking Chinese equities down more than 25% from their earlier peak this year and today’s meltdown in the Turkish lira, we observe relative measures both on technical and fundamental factors reaching elevated levels. We are recommending investors to begin adding emerging market equities hedged against US equities that have been the only bright start in the equity universe since February’s volatility shock.
Today’s trade recommendation is aggressive given the circumstances and fully acknowledges that our timing may be too early, but timing is a poor man’s game. With enough patience it’s our view that beginning to add emerging market equities is the right tactical move.
China and Turkey
The current EM weakness started with February’s volatility shock and then continued as President Trump heated up his attacks on China’s trade policy. Over the past six months the language has increasingly worsened and the deadlock between the US and Chinese government has been obvious. Tariffs worth $50bn on Chinese imports have been partly implemented, the last $16bn starts in two weeks with Chinese counter moves being fired back.
Trump has threatened an additional $200bn in tariffs against China weakening sentiment even further. Chinese equities were down almost 30% at their lowest point and the USDCNY is close to all-time-highs. The Chinese government has already begun various monetary and fiscal steps to accommodate the economy but the impact will not reach the Chinese economy until early 2019.
However, it is our view that the market is likely underestimating the flexibility and fire power of the Chinese government despite elevated debt levels. The impulse from recent stimulus will stage another boom which the market will likely begin to discount within the next three months.
Trouble in Ankara
The weakness in China is part of a bigger sentiment decline in EM, where shares have underperformed the US equity market by 15% this year. Turkey has been the time bomb lurking in the background but the past two weeks' weakness in TRY has elevated the situation from something manageable to a situation that has the European Central Bank’s attention as several Southern European banks have large exposures to the Turkish economy.
The crux of the matter is that the current account has gone from plus 2% when Erdogan came into power to -6.3% in Q1 2018. This is a sign that the Turkish economy has lost its competitiveness but is also dependent on foreign capital to preserve current consumption.
While Turkey is the 17th largest economy in the world with a nominal GDP of around $850bn, its importance in financial market is small. Turkish equities have an index weight of less than 1% in the MSCI Emerging Markets Index, which in itself is around 10% of global equity markets, so Turkish equities have close to zero impact on the market. But the size of the economy is the real threat via European banks and loan losses.
The technical and fundamental mean reversion play
It’s often when others hesitate that one should act. In the case of EM equities the sentiment is definitely weak and “don’t touch” as the strong narrative is that emerging markets are in trouble. When China’s stimulus begins to halt the weakness the market will likely reprice EM as these countries are still attractive and even more so now at the current low valuation compared to developed markets.
While EM were the success story in the period leading up to the financial crisis (and also in the subsequent rebound), the story has been mostly mixed-to-negative since 2013. A stronger USD, higher US interest rates, weaker commodity prices, and worsening current accounts have all created plethora of headwinds for EM countries and changed the narrative to being negative.
In the past five years EM equities are up 29% in USD compared to US equities up 89% in the same period. What makes the recent period extremely interesting is the big divergence in performance. In previous declines the correlation between US and EM equities has been positive but it has been negative in the period since April.
If we look at the total return of indices over the past five years and normalise their relative performance, we observe that US equities have gone to relative levels not seen since 2016 when the last bout of EM outperformance started. Technically this represents a good starting point for increasing exposure to EM equities if historical relationships replay themselves.
If we turn to fundamentals we again observing elevated relative valuation. The S&P 500 trades at 12-month trailing EV/EBITDA of 13.5 compared to 8.7 for EM. The valuation gap obviously reflects the technology sector (new economy) versus industrials (old economy), plus US equity valuation premium due to growth and profitability.
The relative valuation is now attractive enough that we see limited downside risk from valuation.
Overall, both technical and fundamental factors support a positive view on EM and as a result we are recommending a relative mean-reversion play against US equities.
The key risk is USDCNY breaking above the 7.0000 level which would potentially mark a regime shift in China and likely stage another round of tariffs from the US which would exacerbate the situation in Asia. Significantly higher US interest rates or USD trade-weighted spot are also key risks to this trade as it lowers the financial conditions in emerging markets and thus could lower economic activity in EM countries.
Entry: 44.13 (EEM:arcx) & 285.07 (SPY:arcx)
Stop: 5% on the basket P/L
Target: 10% on the basket P/L
Time Horizon: 6 months