Emerging or sub-merging markets

It’s been a tough year for emergingmarket (EM) investors, who have suffered poor returns on headwinds from the Federal Reserve’s tightening of monetary policy and as the rising global uncertainty from the Us-china showdown on trade takes global prisoners.

EMS trade at an unprecedentedly deep discount to developed-economy assets. In statistical terms, EM equity market valuations are three standard deviations cheaper than the US stock market, as the chart below shows.

With such dramatic divergences in performance heading into the fourth quarter, it raises the question of whether this is a “valuation trap” or one of the biggest buy signals for EM in a long, long time.

Whatever the chart above does or does not say about EM assets, at least it argues we should underweight US equity exposure as, regardless of whether we face a sideways market, a market meltdown, or a new melt-up, mean-reversion should favour EM in relative terms, and could potentially reduce overall portfolio volatility because mean-reversion as a factor input is uncorrelated to momentum, which drives most valuations.

Whether to buy EM outright is a more difficult question as it will depend on how close we are to the end of the Fed’s hiking cycle, and likewise whether the US dollar has peaked. But perhaps most importantly, EM could be driven by the timing of the relative recovery in China’s asset markets.

We know that when the US growth outlook over the next six to 12 months is expected to outperform China, this could supposedly drive a stronger USD on additional policy tightening from the Powell Fed, thus increasing funding costs for EM, which are heavily dependent on USD availability to drive their credit impulse. This source of stress and reduced growth in EM represents the dynamic for the last 18 months.

However, when there is cyclical change in growth leadership from the US to China, it will lead to a weaker USD, which will support commodities and emerging economies again as the strong engines of EM restart and make EM competitive.

For now, we estimate that the US economy has peaked – the powerful expansionary cocktail of unfinanced tax cuts, repatriation of capital, and fiscal spending ramped up growth in the US, but these one-off effects will peter out as the year ends. Already the US housing market is showing signs of strain as the higher marginal cost of capital (the higher yield on mortgages, more specifically) is starting to have a material impact on future growth.

As certain as we are about the US having peaked, we are less certain as to how soon China will reach the bottom of its deleveraging process and begin to expand more forcefully again.

We have long said that the declining credit impulse — a shrinking rate of credit injection into the economy — forewarned a slowdown which has now materialised. Despite three moves by China to reduce its reserve requirement ratio (RRR) for banks and boost liquidity and lending, the Chinese banking system remains defensive. The overall plan for China was to reduce the shadow economy by transferring risks from the patchwork shadow lending market to the major banks, a plan that for now has yet to ignite further lending. While US and Chinese growth is becoming more asynchronous, the trade war severely aggravates the risks for the global economy. Pitting the Trump administration’s America First strategy against China’s 2025 plan, both strategies seek further independence from their rival, which means less globalisation, less trade flow, and less sharing of ideas and best practices. The globalisation trend has not only stopped but reversed over the course of this year, and with the US midterm elections looming, we see no slowdown in this war of words for now or even after the November election.

The fact that anti-china rhetoric resonates with both President Trump’s base and Democratic voters is a scary testament to the risks of a new cold war over trade and technology breaking out. It’s almost as if the US needs a new enemy to replace the old one, and a sign of insecurity more than strength.

To round things off, before the year is over we could see new elections being called in the UK (effectively a second Brexit vote), Italy (anti-eu/budget), Sweden (lack of political solutions), and a further widening of the divide in US politics.

We are clearly at a crossroads on many fronts: globalisation, geopolitics and economics. The next quarter will either see dampening of volatility by a less aggressive Fed, more active easing in China, and a compromise on the European Union budget… or a further escalation in the tension seen in all three areas. I would not bet against the latter into Q4, but I remain confident that we stand only a few months away from the beginning of a new easing cycle based on ugly realities, not the hope expressed by politicians and often market consensus.

I am the most optimistic I have been in years about the future, but only because things can hardly get any worse.

Let’s be careful out there.