Strong dollar leaves emerging markets on edge for rest of 2018
A challenging second half for 2018 awaits investors with a number of flashing warnings over a slowing macroeconomic story outside of the US and heightened political and trade tensions. Emerging markets and the threat of contagion A stronger dollar and rising short-term US interest rates have shaken faith across emerging markets with investors dumping stock and bond funds. There are worries that weakness spreads beyond such fragile countries as Turkey, Argentina, Indonesia and India, all of whom have been forced to raise interest rates in an effort to stem currency weakness. Slowing growth in China has further shaken EM sentiment, as investors become increasingly concerned over Washington-led global trade protectionism. China’s renminbi plumbed to its lowest level of the year last month, while India’s rupee has also set a record low on trade jitters and rising oil prices. The Shanghai Composite, a major barometer for Chinese mainland stocks, has entered a bear market. This move has helped to drag the MSCI’s EM index down more than 18 per cent from its highs of the year. Timothy Ash, EM sovereign analyst at BlueBay Asset Management, pointed out that EMs are “facing numerous factors coming together”. However, he said conditions are not pointing to an EM crisis, like the one in the late 1990s. EM policymakers have “tools to manage” in the environment, he said.
Fundamental shift for developed world stocks Nine years into a bull market, US equities are showing signs of strain. The S&P 500 is up 1.7 per cent this year while European national indices are almost all negative since the start of 2018. “If you look out across the world, price-to-earnings multiples are high relative to where they have been in the past,” said Bill Kennedy, portfolio manager for Fidelity International Discovery Fund. “You have high valuations combined with incremental monetary tightening so my base case is that there is probably some downside”. With unpredictable factors such as Trump’s trade policy unlikely to go away investors will be forced to refocus on fundamental drivers of stock valuations, most importantly earnings. In the US large technology companies, which are among the fastest growing in the S&P 500, have outperformed, with the Nasdaq up 8.6 per cent year to date. If these groups continue their growth trajectory then their shares should be able to shrug off frightening headlines from elsewhere. “When making investment decisions, you cannot rely heavily on a re-rating of P/Es,” said Mr Kennedy. “What will drive performance over the next six months is owning companies that are delivering on earnings.”
Treasuries and their relationship with global yields Tightening monetary policy and surging economic growth was supposed to finally call time on an era of ultra low bond yields. It has not yet turned out that way. The 10-year US Treasury yield has stalled at the psychologically crucial 3 per cent level. Other major markets followed it higher earlier this year, but they have subsequently plateaued. Hence, the difference between Treasuries and other bond yields has reached historically wide levels. Meanwhile, weaker prices and higher yields in the eurozone periphery last month were triggered more by local political tensions, led by Italy, than sustained evidence of economic sprightliness. This leaves fixed income investors mulling the prospect of either a global stagnation or a sustained and historically rare divergence between the US and other markets in the second half of this year. Tim Haywood, fixed income investment director at Gam Investments, said there was still plenty of reasons to expect yields to shift higher in the coming months. “The premise that yields would rise has definitely been proven,” he said. Although investors’ risk appetite is “relatively light”, “the underlying economic data are pretty impressive”, therefore “it is appropriate to be somewhat bearish on bonds”, he argued
Corporate debt sellers aren’t having things their own way A troubling sign in the credit market is how the lower end of US investment-grade corporate debt has steadily lost its appeal. The risk premium for Moody’s BAA index over the 10-year Treasury yield has steadily risen this year — from a low of 155 basis points in early February to 200bp by the end of June. The consequences of mergers and acquisitions have been clear in the market: The widest spreads have been found on the debt of acquisitive companies and their sectors, reflecting higher market risk. Another area of concern is waning demand from foreign investors. As of June 22, foreign buying was down 13 per cent from the year before, according to estimates from strategists at Bank of America Merrill Lynch. “Because demand is starting to wane a bit from foreign investors, you’re seeing a lot more volatility in spreads and concession on new issues,” said Josh Lohmeier, head of US investment-grade credit at Aviva Investors. “One of the things we think about is, how do you avoid M&A? . . . as a bond investor, M&A is usually not helpful, as it almost always results in balance sheet deterioration.” In Europe, all eyes are on the European Central Bank, which will stop fresh purchases of government and corporate bonds at the end of the year. The dilemma for investors trying to get ahead of the central bank is that European corporate bonds are already under significant pressure, with the spread on ICE Bank of America Merrill Lynch’s euro investment-grade corporate doubling since January. “We’re worried about the widening of ECB eligible names later this year, but it’s actually already happened,” said Greg Peters, a senior portfolio manager at PGIM Fixed Income. “That makes things difficult.” And with spreads widening, the primary bond market is becoming less predictable. If last year was all about indiscriminate buying, 2018 has been the year that credit differentiation returned. The European high-yield bond market has seen 10 deals pulled in the first half of this year, which many observers believe is a record. Even the normally placid investment-grade bond market has seen issuers call off trades, with Whirlpool and Bertelsmann both throwing in the towel on attempted bond sales in May. Oil bulls have momentum on their side Oil prices had a stellar first half of the year with Brent crude oil reaching a four-year high of $80 a barrel in May — a level it remains near as June ends. The big question for the second-half is whether crude’s 60 per cent rally over the past 12 months is in danger of topping out, but there are plenty of reasons to think it has further to run. Venezuela’s output is in freefall, the US is determined to reinstate tough sanctions against Iran’s oil industry and as long as the wider economy keeps growing demand should remain robust. The flip side is Saudi Arabia and Russia have clearly indicated they do not want prices to get out of control and will be adding more barrels — equal to at least 1 per cent of global supply — in the second half. But some think that will not be enough, with four years of under-investment in the sector crimping wider supplies. “While Saudi Arabia has pledged to raise production to a high of 10.8 mb/d, even this surge may not be enough in the near term given the proliferating supply disruptions,” said Michael Tran at RBC Capital Markets. In contrast to oil, metals have struggled to make headway. Spooked by global trade tensions and concerns about credit tightening and slowing manufacturing sector in China, the LMEX index, which tracks six base metals including, aluminium, copper, and zinc, fell 6 per cent in the first half of the year. Two events loom large in the second half of the year: wage talks at Escondida, the world’s biggest copper mine, and the future of Rusal, the largest aluminium supplier outside of China. Both have the potential to drive prices higher, particularly the situation at Rusal if its parent company EN+ fails to meet an August 5 deadline to win a reprieve from crippling US sanctions. Dollar strength dominates There is considerable uncertainty on whether the dollar’s current resurgence is assured. Much depends on the Federal Reserve sticking to its projected interest rate path of two further tightenings this year, and the hostility in US-China trade tensions. If either or both soften, investors are likely to return to the euro, with the ECB slowly progressing along a monetary tightening path. Krishna Memani, chief investment officer at Oppenheimer Funds, said a “meaningfully weaker dollar” would imply that foreign investors were not funding the US deficit. The pound is likely to weaken further as the clock ticks down to the UK’s EU exit. Investors will also be monitoring the renminbi for signs the People’s Bank of China is allowing its currency to depreciate intentionally. There is some optimism that the less vulnerable parts of EM FX can withstand the strong dollar, particularly when elections are out of the way. But the most important election is in a developed market — the US Congressional midterms. Currencies may well stay rangebound until November.