Real quick here. Here’s a chart tracking EM and S&P500 gains since the beginning of 2016:
Source: Jamie McGeever
How EM closes the performance gap
Two questions:
- When and why should we expect EM and US stock markets to move in unison?
- If they do start to better track each other, how does the performance gap close?
Given the relative value chart I showed you yesterday, it’s clear that the US market is overvalued relative to emerging markets. At the same time, the fundamentals in the US are better. And I see no indications on the horizon that the difference in fundamentals between the US and the emerging markets’ real economies will close. They might just increase.
But this chart suggests that when the gap between EM and the US closes, it will do so because of US underperformance. The way I am reading this is as EM as a canary in the coalmine for downside risk in other risk assets and eventually for the US stock market as well. And that could happen before the real economy in the US turns down, due to credit weaknesses in big sectors of the economy like energy or property.
But I don’t see EM markets turning up in earnest until after the shake out in the US happens. So while I am looking for signs that EM will soon bottom, I still question whether we are still too early on this since I believe the US has a ways to go before it breaks down.
What I’m seeing in the US
I would look to US credit markets first before I look to shares for leading indicators of weakness.
In that context, is the recent uptick in 10-year Treasury yields a good sign or a bad sign? It’s not clear yet. But I look at it as a bad sign because the curve is not steepening. We are still at 22 basis points between 2- and 10-year yields.
Source: FT
And if you look at the levels from a week ago, the 2-year is selling off worse than the 10-year. So even if some of the Fed’s policy is now transmitting through to the long end of the curve finally, we are still getting a flattening curve. With 50 basis points of hikes in the pipeline for 2018, I continue to see the curve flirting with inversion if the Fed pulls the trigger in December as well as this month.
Afterwards, I expect the Fed will continue to raise rates, particularly because inflation has been rising, with the Fed’s preferred measure of inflation finally above target.
If one looks at the inflation consumers see and feel in the real economy, we’re already at 3%, which has made real hourly wage gains nonexistent.
All of this will come to a head in 2019, first in credit markets and later in shares.
Can EM rally at that point on a rotation out of the US and into EM? I don’t see it. More likely, EM has a second downdraft followed by a larger uptick as economies recover based on relative value. For now, unlike Jeremy Grantham, who is dollar cost averaging into EM as shares fall, I continue to believe EM is not a place to overweight.
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