Dollar Strength, EM Stresses = Ongoing U.S. Equity Risk

Today, a discussion about to what extent dollar strength, that leads to EM stresses, will infect U.S. bourses.


Our EM team has been warning for some time that sharply higher foreign-currency debt levels among emerging market (EM) companies and banks will pose a formidable challenge to EM. Indeed, we have written about the risks associated with the end of the “dollar carry trade” (i.e. EM companies’ and banks’ borrowing in U.S. dollars).

With the dollar still rising, concerns about the impact of EM weakness on the U.S. and other developed markets are mounting. Could EM vulnerability to a rising dollar trigger a global financial accident? “Crises” are inherently difficult to time – it is impossible to know when investor behavior/psychology will turn. There are two points that make us leery about EM risks as they relate to U.S. (and other developed markets). First, EM is far more important in terms of its global GDP weighting than in previous decades, implying that when EM catches a cold, the rest of the world will more than just sneeze. Second, with policy options in developed economies nearly exhausted, the tool to deals with a crisis are more limited than, for example the 1990s.

At a minimum, slower demand from emerging markets and dollar strength risk creating earnings disappointments for globally-exposed sectors in developed market bourses. Indeed, the rise in the dollar and poor EM demand have been key reasons why we have advocated a domestic vs. global approach within the U.S. stock universe. A cautious approach is still warranted.

Chinese Debt Swap Program: A Potential Game Changer?

The Chinese government is planning a massive debt swap program to deal with local government liabilities. This could fundamentally change investors’ perceptions about a key risk factor that has plagued China’s macro picture in recent years.

The Chinese press has reported that the Ministry of Finance is planning a RMB 3 trillion debt swap program, which will allow local governments to directly raise debt in exchange for their borrowings accumulated by various local government financing vehicles (LGFVs) in recent years. Although this program has not been officially unveiled, Finance Minister Lou in a press conference on the sidelines of the NPC confirmed such a program has been put forward for approval. If true, it would signify that Beijing’s overhaul of local government debt has reached a final stage.

Last year’s fiscal reforms enabled local governments to raise debt “legally”, which provided a transparent mechanism to address their “incremental” fiscal shortfalls. The proposed debt swap program would be utilized to deal with existing liabilities accumulated at localities in previous years. As the LGFV debt issue has been flagged as a key macro risk, the swap program holds the promise of dissolving a major concern that investors have had with respect to China’s macro picture. It would significantly reduce the perceived credit risk within the financial system and the banking sector.

For now, we remain upbeat on H shares and neutral on A shares, mainly due to valuation concerns. However, the debt swap program, if implemented, will be unambiguously good news for the bank-heavy Chinese stock markets. We will reassess our view in the coming weeks on any material progress on this front.