This emerging markets analysis examines the outlook for capital flows into emerging economies and its impact on emerging equities over the next twelve months and the outlook for the US dollar from the perspective of an analyst/trader that utilizes fundamental, technical, quantitative, and intermarket analyses.
A Lull in Fed Activity
After a false start in Dec (perhaps, planned), the Fed all but rescinds its hawkish interest-rate normalizing strategy as conveyed via recent dovish FOMC meeting decisions, released FOMC meeting minutes, and speeches. Not only would the Fed not be implementing its original three hikes this year (300 bps over the next several years was the original plan) but, perhaps, none at all, depending on the “data” (Chart 1). With the US economy teetering on recession, energy companies facing bankruptcy, at-risk banks and financial institutions confronting massive write-downs, and US presidential elections just seven months away, the Fed will likely hold-off until early 2017, after the energy sector completes its current round of capital raisings, lenders off-load much of their exposed risk, and the new president swears in before making any major decisions. As discussed in the Market Analysis Reports for March 11 and March 29, this author believes NIRP (plus, possibly, QE4) constitutes the next weighty move by the Fed. Thus, this lull in Fed activity presents opportunities for emerging market equity investors.
Emerging Countries’ Capital Flows
As noted by many analysts, in the wake of the 2007-2008 Global Financial Crisis, capital flow between advanced and emerging economies has become sensitive to monetary policies and its effect on interest rates and central bank balance sheets of developed economies. When considering heightened geopolitical and terrorist tension, lackluster economies, and the uncertainty of monetary policies, capital flows, understandably, have grown volatile. The current abatement in Fed action entices global investors to venture abroad in search of yield.
Some emerging economies will attract a relatively larger share of short-term (and even long-term) capital flows over the next twelve months. Countries with a high dependence on foreign capital that experienced large foreign capital withdrawals over the last eighteen to twenty-four months could expect an influx. During the 2013 Taper Tantrum, the so-called “Fragile Five” (Brazil, India, Indonesia, South Africa, and Turkey) experienced heavy portfolio outflows only to see much return in months. Some countries to watch include Turkey, South Africa, Colombia, Brazil, Peru, and Indonesia – all with high current account deficits that rely copiously on external debt and portfolio equity flow (positive net debt and portfolio equity flows) for financing. To a lesser extent, Poland and Chile could also see strong capital inflows. Interestingly, Argentina, under new President Mauricio Macri, recently settled its dispute with hold-out foreign bond investors and has taken aggressive steps to tackle the country’s problems and seeks to raise up to $15bn in international debt markets in April to settle the bill with holdouts – upon success, more capital raisings would follow to fund government expenditures and to boost depleted foreign currency reserves (Table 1). Also, India could see healthy capital inflows as it weathers the global economic storm better than most, expecting its economy to grow by 7.5% this year– a tad optimistic, perhaps, but significantly better than other economies. And, of course, Mexico, with its close proximity and integrated economy (to the US) could expect a rush of incoming capital. Furthermore, smaller developing economies sporting higher current account surpluses could see a bump up in allocation that would launch local equities: Vietnam, Philippines, and Thailand. Malaysia could be included in this last group, however some money managers still hold concerns over the 1MDB scandal. Another faction that could benefit are emerging commodity-producing countries.
Relief for Commodity-Producers
Since the start of the 2007-2008 Global Financial Crisis, commodities get hammered. But, the widely-broadcasted ending of QE3 creates a massive “risk-off” environment, commencing the summer of 2014, that sends USD parabolic and commodities on its next downleg (Chart 2). The recent dovish stance of the Fed enables commodities to finally form a bottom (Chart 3). Will it stick? Commodity fundamentals remain horrid, but as the adage goes: “Don’t fight the Fed.” And, the corollary: “Especially during a presidential election year.”
Emerging commodity-producing country equities bottom and track commodity prices upward in near lockstep, from mid-Jan 2016 (immediately after NY Fed Pres Dudley speech). As expected, high net commodity-to-GDP economies lead the way. The steep rise in UAE equities suggest the market expects bullish oil prices to continue, which Russia and Indonesia certainly cheer. Even problem-riddled Nigeria is forming a trough (Chart 4). For moderately high net commodity-to-GDP economies, Brazil and Colombia stage a remarkable turnaround zooming from group laggards to top of the class in several months (Chart 5). The prospect of Macri winning the presidency helps push the Merval to an all-time high. And, the long-awaited settlement with foreign bold holdouts and a state visit by Pres Obama solidifies Argentina’s planned return to the international debt markets (Chart 6). Argentina’s return is timely as the USD Index nears completion of a one-year topping formation (green circle in Chart 2 and Chart 7) that would lead to USD weakening for the indefinite future (USD Index next probable target: 85, a 10% depreciation), thereby making future repayments in relatively stronger pesos more attractive.
The Weakening US Dollar
Emerging economies benefit from a softer dollar in several ways. China gains as pressure lessens on the PBOC, which removed its peg to the dollar and allowed the renminbi to weaken against the strengthening greenback (Chart 7). Thus, watch for the PBOC to “re-peg” to the weakening USD, thereby helping exports. But, pressure increases on other emerging exporters, who may further loosen monetary policies and lower interest rates to defend its exports – the currency wars continue.
As already mentioned, commodity-producers enjoy a fillip and capital inflows into emerging economies could pick-up significantly that would boost local equities and bump up local and international bond prices, jump-start FDI and M&A activity, replenish depleted foreign exchange reserves and help finance current account deficits, and should local currencies strengthen vis-a-vis the dollar, imports of raw materials, natural resources, and machinery and equipment become attractive. Also, a weaker dollar brings relief to US dollar international bond holders as underlying names get a credit rating pop due to improving emerging economies and repayment spur, as mentioned for Argentina.
As business activity springs to life, local consumption rallies, particularly for discretionary spending; the lending cycle swings upwards to reinvigorate whole swaths of industries: banking, brokering, insurance, residential and commercial construction, existing home selling, appliances, home furnishing and fixtures, houseware and accessories, office supplies, packaging and containers, paper and paper products, textiles, auto and trucks, construction equipment, business equipment, electronic equipment, computer equipment and software, communication systems, foods, cement, farm and construction machinery, building materials, industrial electrical equipment, industrial equipment, lumber and wood, machine tools and accessories, tools and accessories, waste management, and all types of consumer and business services. For emerging market investors, all this adds up to finance, cyclical, and technology stocks advancing first, closely followed by industrials.
Nevertheless, emerging exporters require a destination for their goods and services. Is China’s economy large enough and ready to sufficiently supply demand for final goods? What about India? Surely, rich or large commodity economies, like a rejuvenated Canada, Australia, Russia, Indonesia, Brazil, Nigeria, and Mexico would draw-in products. Little help from Continental Europe, which remains weighed down by a horrendous banking situation, a swarm of refugees, terrorist attacks, and a populace that grows more scared by the day. Also, the UK is not in the buying mood as it contemplates Brexit and economic life thereafter (what happens to existing EU trade, banking, and financial agreements), while staring at a current account deficit-to-GDP of 5.2% (2015), total official national debt-to-GDP of 81% (2015), and total external debt-to-GDP of 569% (2014). So, who does that leave?
How long this downleg in the USD lasts is anybodies guess. But, as previously examined, a US move to NIRP could cause economic and financial market linkages to eventually unhinge as the dreaded “Doom Loop” (see Market Analysis for Mar 11 2016) becomes reality to create a self-inflicted implosion and strong inflation (and, even possibly, hyperinflation). In the most extreme case, USD Index approaches the zero limit and some form of SDRs takes over (most likely backed by some portion of gold), but not before global economies and financial markets are thrown into disarray. No wonder China tried so hard to get the renminbi added (effective Oct 1 2016) to the IMF SDR basket (and a seat at the next global financial system re-set). That would also help explain China, Russia, and other nations’ obsession with gathering gold.
Until that event occurs (Japan remains upright after two and half decades of deflation), however, America awash in liquidity, albeit tied up in the financial markets, could overturn its pessimistic posture with a new president at the helm to get businesses to invest, expand, and hire again (fast-food and temporary teaching jobs don’t count) so that consumers feel stable enough to start spending once more to keep the global economic ball rolling. Combine that thought with the prospect of the strengthening (after three years of free-fall) of the world’s third largest economic currency (which, of course, helps its consumers and boost imports; Chart 8) and the posed paradox is solved: US and Japan to the rescue with back-up support from the OECD (many of whose currencies shall appreciate vis-à-vis USD by default, with the Brexit exception of the UK and GBP; Chart 9). Thus, watch for emerging market stocks (and emerging domestic and international bonds) to put in a relatively decent performance over the next twelve months, or so. And, should the Fed decide to buttress its dovish talk with action (ZIRP, NIRP, QE4) before then, back-up the truck. Or, at least, that seems to be Plan A. Of course, Plan B could always be dusted-off and enacted: War.