DE­VEL­OPED STOCKS CAN’T IG­NORE EMERG­ING LAWS OF GRAV­ITY MUCH LONGER

The Gulf Today - Business - - SPECIAL REPORT -

LON­DON: The re­la­tion­ship be­tween de­vel­oped and emerg­ing mar­ket eq­ui­ties has bro­ken down, and by some mea­sures, the frac­ture hasn’t been this deep in over 20 years.

The ques­tion now is whether emerg­ing mar­kets re­cover and catch up with their de­vel­oped peers, or does the tur­moil that has en­gulfed EM this year fi­nally spill over into DM too? While there’s a case to be made that emerg­ing stocks are close to bot­tom­ing − they’re in a bear mar­ket, af­ter all − in­vestors are in no rush to get back in yet. The crises in Ar­gentina and Turkey sug­gest that cau­tion is war­ranted.

In which case, de­vel­oped world stocks are vul­ner­a­ble.

The sim­ple monthly cor­re­la­tion be­tween the MSCI bench­mark emerg­ing in­dex and the S&P 500 is cur­rently run­ning at 0.38, the low­est since April 1996. It has halved since Jan­uary, when it hit a four-year high of 0.76.

A read­ing of 1.0 in­di­cates the strong­est pos­si­ble cor­re­la­tion be­tween two as­sets or mar­kets, and -1.0 the strong­est pos­si­ble in­verse cor­re­la­tion.

The break­down re­ally be­came ev­i­dent around May. Events in Ar­gentina and Turkey, cou­pled with deep­en­ing weak­ness in China as trade war ten­sions es­ca­lated, sent emerg­ing mar­kets into a tail­spin, while Wall Street got its mojo back in large part thanks to a re­cov­ery in tech.

A sim­i­lar weak­en­ing of this cor­re­la­tion also emerged in 201415, cul­mi­nat­ing in a fall to 0.48 in July 2015. At that time, it was the low­est since 1997.

The MSCI emerg­ing bench­mark was al­ready in a bear mar­ket then and con­tin­ued to de­cline into early 2016, its losses over the pe­riod to­talling around 35 per cent. What Wall Street did next is in­struc­tive.

The S&P 500 had held up strongly but fi­nally buck­led in Au­gust 2015, fall­ing 10 per cent in a mat­ter of weeks be­fore re­cov­er­ing.

A few months passed be­fore it buck­led again, slid­ing an­other 15 per cent in early 2016.

Will his­tory re­peat it­self this time around? Much might de­pend on the dol­lar.

Its rally this year, to­gether with the rise in US in­ter­est rates and bond yields, has ham­mered emerg­ing mar­kets, which have large ex­po­sure to dol­lar-de­nom­i­nated fund­ing.

An­a­lysts at Deutsche Bank reckon the dol­lar is the most over­val­ued cur­rency in the world right now.

A pull­back might ease the pres­sure on emerg­ing eq­ui­ties, while bold in­vestors might be tempted back into EM stocks by cheap val­u­a­tions.

But the down­side for emerg­ing eq­ui­ties could still have fur­ther to run. Ac­cord­ing to fund flows tracker EPFR, cu­mu­la­tive flows into emerg­ing eq­uity funds topped $100 bil­lion early this year, the high­est since 2013. That has be­gun to re­v­erse in re­cent months, but there’s scope for much more profit-tak­ing.

“We ac­knowl­edge emerg­ing mar­ket eq­ui­ties have al­ready un­der­per­formed over the last few months, but think it is too early to in­crease ex­po­sure again yet,” Bar­clays an­a­lysts say. An­a­lysts at Gold­man Sachs are more op­ti­mistic.

They had long emerg­ing eq­ui­ties as one of their top trade rec­om­men­da­tions at the start of the year, tar­get­ing the MSCI emerg­ing bench­mark in­dex at 1,250 points.

This week the in­dex fell be­low 1,000 points, putting it deeper into un­der­val­ued territory, an es­ti­mated 5 per cent off the rel­a­tive val­u­a­tion cy­cle low of Jan­uary 2016 which Gold­man reck­ons marks a “sig­nif­i­cant” floor.

Mean­while, the US econ­omy, prof­its and stock mar­kets are boom­ing rel­a­tive to the emerg­ing world and in­deed the rest of the world in gen­eral. But the like­li­hood grows that this spurt, nearly a decade into the eco­nomic and mar­ket re­cov­ery, is run­ning on late-cy­cle fumes and the re­cent fis­cal boost.

Ac­cord­ing to Fathom Con­sult­ing, the chances of a US re­ces­sion by the end of 2019 will be as high as they have been in more than 60 years.

Al­though not ev­ery­one buys into it, the US yield curve barely 20 ba­sis points from in­vert­ing strongly sug­gests the econ­omy is set to slow. And his­tory shows curve in­ver­sion her­alds re­ces­sion, al­ways.

“Even­tu­ally the fis­cal stim­u­lus will fade. We know that’s a one-off, the boost to GDP is a one-off, and the boost to earn­ings is a one-off. It will fade,” said JP Mor­gan’s Niko­laos Pani­girt­zoglou. It can only be a mat­ter of time be­fore Wall Street be­gins to price in the re­ver­sal.

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