Saturday, January 12, 2019

Important: "Emerging markets can't escape the Fed's balance sheet unwind"

Throughout 2018 it was so tempting to shift assets to emerging market equities using any number of rationalizations: absolute valuation; relative valuation versus U.S. markets; geographical diversification and on and on.

Here's the iShares MSCI Emerging Markets ETF, one of the most liquid of the proxies:

EEM iShares MSCI Emerging Markets ETF daily Stock Chart
Weighted P/E 12.10 with the caveat that six of the top 10 holdings are Chinese so maybe not as 'frontier' as one might desire

And here is the problem. After peaking in January 2018 the thing looked cheap and got cheaper, reminiscent of this:

We first posted this cartoon on September 5, 2008:
That's Alfred Frueh's January 16, 1932 New Yorker classic, "Just around the Corner", commenting on President Hoover's statement that "Prosperity is just around the corner".
as a reminder of how extended a decline can be and how they can fool you.
  • On September 7, 2008 Fannie Mae and Freddie Mac were placed into conservatorship.
  • On September 14, 2008 Merrill Lynch agreed to be acquired by Bank of America.
  • On September 15 Lehman filed their bankruptcy petition.
  • On September 16 AIG became a 79.9% subsidiary of the U.S. Treasury.
  • Within 10 more days the Nation's largest thrift, WaMu was seized and five days later Wachovia was gobbled up and we were off to the races.
Good times, good times.
We only had to re-post the cartoon nine times in the next six months.

And the reason for this longer than usual introduction?
Colby Smith at FT Alphaville, January 10
When Federal Reserve Chairman Jay Powell said in December that the central bank's reduction of its balance sheet was on autopilot, global markets balked. When he later walked back that statement at the annual meeting of the American Economic Association and assured that the Fed “wouldn’t hesitate” to alter its balance sheet policy if needed, investors cheered.

Few markets have gyrated on the comings and goings of this so-called "quantitative tightening" as wildly as emerging markets. As primary beneficiaries of its counterpart, quantitative easing, in the aftermath of the financial crisis, and the subsequent reach for yield as interest rates in developed economies fell, the fate of emerging markets is tethered quite closely to decisions made by the Federal Reserve.

Despite Powell's new promise for patience when it comes to unwinding the balance sheet, an outright pause appears unlikely. For emerging markets, which have already felt substantial pain this year from this shift, the situation could deteriorate further.

Accelerating in earnest from 2009, the Fed snapped up US Treasuries to inject liquidity into the system and mortgage-backed securities to prop up demand for what were once considered safe assets. This helped to ease financial conditions and borrowing costs as prices rose and interest rates fell. Central banks across emerging markets followed suit, as did the Bank of Japan and European Central Bank. As Matt King of Citi shows in the below chart, that process has begun to taper off in some economies, and in the US, reverse altogether. The pace is set to quicken this year:
What this level of support helped to do was to allow non-financial corporations to pile on debt very cheaply. And that they did. Private credit in China and across emerging markets ballooned. Businesses in developed markets imbibed as well, but to a much smaller degree. Now, with central banks rolling off their balance sheets, King points out that private credit has started to shrink, too:...
...MUCH MORE (the good stuff)

See also the next post "The Fate of the Dollar Will Shape Financial Markets In 2019".

At some point(s) in time EM economies and their equities have a relationship. Whether causal or spurious, or if there are leads/lags, overshoots, undershoots or bumbershoots, we'll leave to others.
Further your affiant sayeth naught.