Many factors are going around for the cause of the Emerging Market selloff. Trade wars, high debt loads, or trade deficits. These factors are always a tinderbox for a financial or economic crisis but not the spark. In this case the main factor of the strain is not a tweet or a 'sudden' realization of poor economic fundamentals. It was the steady and consistent rise in the Dollar.
The rise in the Dollar starting in late 2014 has put a strain on emerging markets but interest rates in the US were still very low compared to local currencies. in 2017 we saw rates on the 2 year and other shorter dated securities start to rise as rate expectations took hold in the markets. It wasn't until Sept. of 2017 that markets started to believe in the FEDs message and rates went up aggressively on the short end of the curve. This is where the real pain came in for EM as higher rates and a stronger Dollar made it very difficult to get out of debt obligations as well as finance the existing ones.
With the Jackson Hole meeting coming up at the end of this week we may see another turning point this September as well. One where the Fed talks back some of the recent hawkishness in light of the global signs of a slowdown or the more likely scenario. The data in the US shows there to be more need for rate increases to keep inflation at bay. There is little evidence in the US that higher rates are affecting the economy so there is no reason for the FOMC to worry, and it would be prudent to have higher rates in the future so the US can better stimulate the economy if the slowdown does occur. This message does not bode well for Emerging markets. But in this lies opportunity, with the US market hitting a record high again today, it might be a good time to pull some money off to the sidelines and await a good buying opportunity in EM. After all you are getting a higher yield while you wait.
The markets are experiencing downward pressure in Asia that is sure to flow into the US by morning. The US has laid out more tariffs to put in place after China retaliated to the first set of tariffs that took effect last Friday. This back and forth will not end well, specifically for the US as they import more from China than China does from the US. The news talks a lot about the trad spat affecting the US economy and there are legitimate concerns as the trade war heats up. It is important to look at China as well and the measures they will have to take to keep the economy on stable footing.
As of now we are seeing the currency weaken and the stock market sell off to some degree. But the important thing to look out for is instability in the financial and property markets. Bad signs in these sectors will show there could be coming problems in the debt market possibly starting a crisis where the government will have to step in.
In a light week for the US a lot of data that will be impacting the current economic story will be coming out. The market movements after quarter end, during a holiday week, will be difficult to get any meaning from. Some of the important takeaways for the broader narrative are as follows:
Oil supply: As President Trump tweets that Saudi Arabia is going to increase output by 'up to 2 million barrels' a day, the price of oils is going to be squarely in focus. For this week we have Thursday and Friday oil inventory and rig counts respectively. This will be important to see how much of the US is ramping up production to fill the demand left from Iran and Venezuela having a decrease in output. Should Saudi Arabia increase output at the same time as US companies try to ramp up production, we could see oil come off its highs.
FOMC minutes: The minutes to the Fed meeting will help to solidify the perception of the US continuing to increase rates at a time that other countries are struggling to get their economies to a level where they can stop stimulus and increase rates. Economic news out of the US seems to support this, the only surprises that could come out of the minutes would be worries on trade or global growth. This could link the political and macro environment closer to future rate expectations.
Jobs data: The actual economic indications of the US economy will be important because of the US currently being an outlier. In order for the markets to keep with the notion that the US is strengthening despite the global markets, the data will have to continue to support that assumption. Should this not occur, many of the correlations we are seeing could start to break down.
Political headlines: Finally the political headlines out of Europe, with Germany's coalition back in crisis, and the US rhetoric on trade wars; there is no doubt to be some chop this week. These issues have been spooking investors in the equity markets and currencies to an extent, but the bond market is still sticking with the broader story that the above data points will be a factor in.
The ECB comes out leaving rates unchanged, until at least a year from now. Asset purchases are to remain until the end of the year. The news was overall expected because of the talks Draghi had in the past week. The interesting news I on the time frame that is given for the interest rate increase.
By putting the interest rate increases a year out, the ECB seems to be using language as a way to express loose policy and not to cause a panic in the markets of raising too soon. This had the Euro adjust drastically to the dollar, the longer term trend will come from the believability of the ECB statement.
If the Fed can continue to raise rates alone, while the ECB stays put for at least a year, the Euro will be beaten up by the dollar over that time frame. If the signals from economic data in Europe start to challenge that assumption we could see the Euro having to play catch-up. The speech will be important to see how strong these statement beliefs are.
Wednesday of this week will most likely see the Fed increase interest rates to 2%. The economic data has been strong enough to convince the committee that more rates are needed to stay ahead of inflation. The rate increase, and the language of the statement, are expected to confirm the growth differential between the US and other major economies. If this occurs then the rally in the dollar could continue. The result of the Fed meeting will shortly be followed by the ECB meeting on Thursday.
After taking a more bullish tone recently, the ECB has an opportunity to align market expectations to theirs at this meeting. Since the Italian elections and the threat of a referendum that would put into question the need to stay into the Euro we have seen market participants put a gloomier outlook on the Euro countries than the ECB.
Eurozone CPI had a preliminary reading of nearly 2% and that is being confirmed this week. Core inflation is still low, but is also showing a spike in the preliminary reading. GDP, while recently pulling back, is close to multi year highs. There is a growth differential at the current moment. Whether the US comes back into the fold of the rest of global performance, or is leading the way to higher growth rates in the developed world will not only be decided by the markets, but checked by the data and the Fed. This week will be one of those checks.
Today there was some ease in the Italian bond market as the country successfully auctioned off intermediate term debt without any issues. This was good to see a drop in yields for the country but also a rise in the Euro, which has been highly correlated to the conditions coming out of Italy. This is welcome news as the perception of immediate danger to Italy (and the Eurozone as a whole) are put into perspective. Longer term there are still dangers that exist and need to be addressed for a true reversal to take place.
The issues with Italy have just started to spread to the global markets and this relief of pending doom was much needed. In order for it to last the Italian government will need to change their tone on the need to stay within the Euro and build a strong coalition that believes in carrying out existing contracts with Europe. This prospect might be too much to ask without another round of elections to (hopefully) show the people's discontent with the League and Five Star's abilities to manage a coalition. This is not something that will happen overnight, but steps in the right direction as the coalition scales back their rhetoric in order to form a government will go a long way.
Another important factor that needs to take place is to have the rest of the Eurozone acknowledge this issue and start to be more vocal about further integrating the currency bloc. By showing a willingness of other major countries to go in the right direction, and build a more stable monetary union, markets will keep the contagion of the Italian election to Italy. Positive news of better monetary integration would help to defang the message that the far right used to get elected, forcing them to change tact.
Amid the Italian elections and other geopolitical factors that are causing investors to run towards the dollar, there is some potential for good news coming out of Europe. First there is the news that Brussels will shortly be unveiling a plan to create sovereign bond-backed securities. While the acceptance among all countries will be a key factor in the success of the plan becoming reality, the rollout will show if the Euro countries will be ready to start talks about a tighter monetary union.
This leads into June where a summit will take place to reform the union. Much of this will be about Security, migration, and innovation, but also include Jobs, and long term budgets. It will be important to see how the countries come together on all of these issues. Showing a willingness to grow tighter together or continue to put their countries first. This will be important in the bond market in terms of spreads as fears of a slowdown start to form. During the first Eurozone crisis the political will was there for countries to make decisions that saved the union. This time the political landscape in the southern countries and nationalism exacerbated by migration in the north, will not make a second round of ad hoc measures works as well. Unity needs to start before the cracks start to form.
The dollar rally has been causing headwinds in emerging markets, with Argentina and Turkey being the noticeable victims at the moment. This rise in the dollar seems to come from two major factors, monetary policy and divergence in growth. We know that the Fed is moving into a tightening phase while many other major central banks are still easing. There is also signs that the global economy did not perform as well in the 1st quarter with the exception of the US, which is still maintaining its rosy outlook. Among advanced economies we see an example of the Euro being singled out as performing poorly.
Over the past month the slowing growth in Germany has caused capital to move out of the bloc. Italian politicians are still trying to form a government from the March elections, and with concerning results as news of the coalitions agenda are being revealed. Germany is resisting Macron's agenda for more economic unity within the region as Angela Merkel tried to keep their coalition happy. This is the issues that has made the Euro fall to the dollar from its really last year, slowing growth in the region and no real unity among the countries to do so. This needs to be watched because the disunity, while not the cause of these issues, could prevent the necessary steps to support growth from being enacted.
Brent reaching $80 a barrel is taking the headlines this week. Supply issues in Venezuela, sanction concerns from Iran, and lower inventories have all played their part in the rally. This has occurred with a rising dollar, making the rise in price more pronounced in other currencies.
Since the end of the first quarter Brent has rallied nearly 15% in dollar terms, this was amplified for other developed countries and especially acute in developing countries. In Turkey, where they are net oil importers, a strain on all stocks, bonds, and the currency have taken place. While there are plenty of political issues with the country at the moment that is shaking investors confidence, high oil prices will take a toll over time on the growth in the country.
There isn't much talk outside emerging markets about the price of oil having an effect on the overall economy yet. But looking at the countries oil prices in local terms, it would be easy to find the first to be affected.
Trump has just announced that he is considering another $100bln in trade tariffs to put on China. This brought the markets down in overnight trading about 100 basis points (1%). This is not a new phenomenon, we have seen the market move higher and lower each day (and sometimes intraday) based on news on trade war talks. Trying to gather the signals from the noise is difficult with the news swirling around the hypotheticals of which companies and sectors are set to lose the most. There is a real danger associated with a trade war and it should be taken into consideration when investing, but taking from a realistic perspective.
The reality is, that the concept of a less friendly US trade environment has been priced in. The current volatility is coming from the talks of tougher trade turning into targeted threats, but what is to actually come of these threats. As we saw with the NFTA talks, there is a lot of tough talk going into the negotiations and then a slow and gradual retreat as time went on. This is a negotiating tactic we have seen from Trump over and over, set the talks up as if you don't need to be a part of them so the other side has to make concessions just to keep you at the table. We seem to be in this phase of the Chinese trade talks now.
From the Chinese side, time is on their hands. With midterm elections coming in the US, any targeted threats towards republican districts in could see the Democrats take back one of the chambers and show that Trump is likely to be a 1 term president. At this point the Chinese can just make enough small talk and concession long enough to wait out the presidential term. If the opposite is true that the Republicans get a re-affirmation of their standing by Trump and his tactics, things could really heat up. In any case the near term threat seems heavy in words and light in action, so this volatility should be used as an opportunity to reposition assets.