EMD Relative weekly notes
Week Ending February 19, 2016
Since the February 11 market lows, the S&P is up about 5% and emerging market sovereign dollar spreads have tightened by about 18 basis points. Our three key investment themes remain intact and have probably been strengthened with additional information:
1) CNY stability leading to a reduction of perceived China tail risks: The CNY has appreciated about a percent following the head of the central bank’s interview last weekend. Earlier, we posited that the Chinese policy-making team needed to improve communication with markets, and they continue to show signs they are doing so. The current episode is looking more or less like a repeat of last August, when an ill-fated sharp currency depreciation led to global risk off for a number of weeks.
2) Oil stabilization: The market quickly discounted an agreement between the Saudis and Russians to leave production unchanged, but we think it was significant for two reasons. First, if the agreement is upheld it represents a reduction of Saudi exports this summer, when domestic demand increases seasonally by about 500,000 barrels a day. Secondly, while we have been skeptical of a broader deal, and while it may still be a less than 50% probability, this seems like a necessary precursor and first step to getting Iran on board through some more complicated deal that takes into account the lifting of sanctions and need to increase production there. Apart from that, the US rig count continues to decline rapidly and debt-financed production continues to disappear, so future supply reductions look well on track.
3) Major central bank policy divergences narrow: US economic data continues to seem soft enough to keep the Fed at bay given the poor market reaction to December’s move. At the same time, the Atlanta Fed ‘Nowcast’ shows a 2.6% forecast for current quarter GDP; so a plunge into recession also seems unlikely. We continue to await more permissive ECB policy next month, but with the Fed still out of play the dollar index has continued to tread water.
When market sentiment improves, it is easy to point to the factors that in retrospect looked sure to be the drivers. But one factor remains of paramount importance to us, and that is liquidity flows into the asset class. When they change for the better, asset prices rise. Whether with a bit of a lead or a lag, this is a solid rule. The following chart compares the sovereign dollar index with the change in FX reserves for an aggregation of key EM countries (absent China). In early 2015 after a disappointing January for asset prices, the market then rallied until April, followed by a steady sell-off to the present — the reserves change captures that well. But what is notable, in our view, is the sharp rise in the most recent data — that seems a great sign for the probability of market gains continuing to consolidate.