Fade the Emerging Market rally
In defiance of conventional wisdom, the oil price has tumbled -10% in the last two weeks despite a weak US dollar. For emerging market investors, the breakdown of this correlation raises tricky questions. On the one hand, the worry is that EMs track the oil market into a renewed death spiral as credit concerns again rear up, while optimists will hope that continued US dollar weakness remains a soothing analgesic, whose effect overrides all else. The answer to this conundrum depends on an assessment of three key drivers of EM performance in recent years, namely, the oil price, EM financial conditions and China’s economic outlook.
First up, EMs as a group need the oil price to stop falling as its precipitous decline since July 2014 has proven to be a net negative to global growth, rather than serving as the hoped for “tax cut”. It is clear that resources were the subject of a major capital misallocation episode over the last decade and the resulting negative adjustment has been most severe in EMs as they benefited disproportionately during the bubble phase.
The good news is that the oil price plunge from $110/barrel to a low of $30/b is spurring a production response. Resources capital spending as a share of global GDP has already fallen to 2008 levels. The less cheery news is that the bear market in oil probably has a long way to run as production discipline is only being applied to “future” output. The prospect of a freeze in current output has foundered on the rocky terrain of Saudi-Iran relations, while Russia is pumping crude at the fastest rate in almost 30 years. As a result, the oil price is likely to range-trade which lowers the chance of an EM credit event. The issue for resource-driven EMs is that they must find a new growth driver, while manufacturing supplier economies, mostly in Asia, must find new export markets. Until such a time, EMs will trade fitfully on the ebb and flow of the oil price.
Another consequence of the preceding emerging markets boom is excess corporate leverage. As a result, a deleveraging dynamic which started with commodity producers has spilled over to other economies through a massive US dollar rally versus EM currencies (the result of producers scrambling to repay dollar debt). The good news on this front is that the risk of a US dollar squeeze has fallen due to the US being in a phase when it is shipping dollars overseas through its trade deficit.
Still, the apparent topping out of the US dollar does not mark an end to tight financial conditions in EMs. The liquidity provided by the wider US trade deficit lowers the chance of an outright crunch, but at this stage is not enough to boost growth. Debt servicing remains painful as income growth has been weak. Even for EM manufacturing exporters, times remain hard as global trade has merely tracked global growth, while continued high capacity across a range of sectors has eroded their pricing power. By the end of 2015, the aggregate debt-serving burden in emerging economies had risen to match that in developed economies, while the same ratio for the private non-financial sector has surged beyond the peak registered in the 2008 global crisis. As a result, EMs remain vulnerable to any negative shift in global market psychology; such an outcome is easy to see since investors, perhaps optimistically, expect less than one US interest rate hike this year.
Of the three factors, China is the only one where the stars seem to be aligning positively, at least on a tactical basis. The worst period of capital outflows has passed.
Meanwhile, demand-side policy, such as faster credit creation and an engineered rebound in the property market is unfolding. Prices of building materials have rebounded, especially cement which is particularly sensitive to final demand. My concern remains that any cyclical recovery, spurred by stimulus spending, will ultimately prove damaging if the private sector does not get a full starring role. Thus far, the worry lingers: capital spending growth in the first two months of the year was driven by state-sector spending rising 20% while private sector investment growth has slowed to 5%.
As a result volatility is likely to remain the buzz-word for EMs. Expect continued violent rallies and sell-offs like those seen since the start of the year, with key factors being investor positioning. While the massive underperformance of EMs may have passed its nadir, this does not signal the start of a new secular bull market.