The Search For Yield And Emerging Markets

The global search for yield – not an improvement in EM fundamentals – is what has been driving the EM rally this year.

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Having turned dovish in February, the Fed has enticed investors to sell U.S. dollars and pile into commodities and risk assets. This phenomenon escalated following the late June Brexit vote. The uncertainties over Brexit and global deflationary pressures led investors to conclude that the Fed would be unlikely to tighten policy meaningfully anytime soon. As a result, the search for yield has gone exponential and flows into EM have skyrocketed.

There is a limit to how far financial demand can propel commodities prices and EM risk assets in the absence of stronger final demand and corporate profits. If final demand disappoints, commodity prices will roll over and drive EM risk assets lower. The chart above demonstrates that there is still a very high correlation between EM share prices and industrial metals prices.

Bottom Line: The global search for yield has driven EM risk assets higher amid lingering poor fundamentals. Our EM strategists believe investors will eventually re-focus on EM macro fundamentals and corporate profits. Once this happens, it will produce a major reversal in EM risk assets: share prices, currencies and high-risk bonds.

Trump And U.S. Treasury Yields

Given recent improvements in global growth and breakouts in global bourses post-Brexit, the low bond yields represent a conundrum. Could Trump really be an answer to the puzzle?

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The 10-year nominal rate is inversely correlated with the probability of Donald Trump winning the U.S. election. So why buy Treasurys as a hedge against a Trump presidency? Generally speaking, Trump is a reason to own safe-haven assets for two reasons:

Trade: Trump could start a trade war with China in 2017. The consequences of a mercantilist America would be profound, potenitally throwing the world economy into a 1930s-like “beggar-thy-neighbor” spiral at a time when global trade is already weak.

Geopolitics: Trump is right when he says that the world is a mess because America is weak. The rest of the world has become a lot more powerful in the last two decades of relative peace and prosperity. The end result is global multipolarity, where numerous countries can pursue their interests independent of one another. We know from political science theory, formal modeling, empirical analysis, as well as the last five years of conflagrations that such a distribution of power is the most likely to create the sort of “messy world” that Trump claims he will “fix”.

Our U.S. bond strategists are not too surprised by the above relationship. They have pointed out that economic factors alone cannot explain the most recent downleg in bond yields. Rising “policy uncertainty”, which includes U.S. politics, has also been depressing bond yields.