A Warning Sign For EM Equities

A relapse in industrial metals versus lumber prices is a poor omen for EM equities.


The ratio of industrial metals to U.S. lumber prices has had a reasonably good track record in gauging relative performance of EM versus U.S. share prices. Industrial metals prices are a proxy for economic growth in China/EM, while U.S. lumber prices are indicative of America’s business cycle. Industrial metals prices (the LMEX index) have lately underperformed U.S. lumber prices, pointing to renewed EM underperformance versus the S&P 500.

Heading For A Choppier Market

Equity markets have given up some of their recent gains. Below, we highlight the critical variables to gauge whether a correction will devolve into a sustained sell-off.


Investor confidence can be measured through margin debt. While extremely elevated, there is no concrete sign that access to funds is being undermined by the modest backup in interest rates. When the cost of borrowing becomes too onerous, it will manifest in reduced margin debt and forced selling.

M&A activity is losing momentum. A peak in merger activity typically coincides with a rising cost of capital. If corporate sector capital availability becomes a pressing issue, then M&A activity will decline further, signaling that the corporate sector is facing growth headwinds.

Economic signals are mostly positive. Durable goods orders have tentatively perked back up, reinforcing that profits and confidence have improved after a soft patch.

Temporary employment continues to rise. When temp workers shrink, it is often an early warning sign that companies are entering retrenchment mode. If temporary employment falls at the same time as share prices, that would be a red flag.

The relative performance of consumer discretionary to consumer staples can provide a read on purchasing power or the marginal propensity to spend. This share price ratio does not suggest that any consumption concerns exist. If consumer staples begin to outperform, then it would warn of a more daunting economic outlook.

In all, these indicators suggest that any pullback will be corrective rather than a trend change.

ECB Versus Fed: A Major Mispricing?

The expected difference between ECB looseness and Fed tightness two years ahead stands near a 20-year extreme.


We have shown there is no difference between economic growth, inflation, or inflation expectations in the euro area and the U.S. on an apples for apples comparison. And in sharp contrast to the U.S., the percentage of the euro area population in employment is at an all-time high.

ECB President Draghi points out that “the risks surrounding euro area growth relate predominantly to global factors”. If these global risks do materialize, it would prevent both the ECB and the Fed hiking rates through 2018. But if these global risks do not materialize, allowing the Fed to continue hiking through 2018, is it really conceivable that the ECB just sits pat? Our European strategists think not.

The Fed’s “Unhike”

Financial assets rallied, while the dollar declined in the aftermath of yesterday’s FOMC meeting. This resulted in an easing in financial conditions, making the Fed’s actions an “unhike” of sorts.


The FOMC meeting produced a number dovish surprises. First, the median Fed forecasts still calls for three hikes this year instead of four, as some observers had anticipated. Second, the estimate for the structural rate of unemployment was scaled down further by a tenth of a percentage point to 4.7%. Third, the FOMC statement said that the Fed was looking for a “sustained” return to 2% inflation, while also referring to its inflation target as a “symmetric” one. Fourth, Minneapolis Fed President Kashkari dissented in favor of keeping rates unchanged, which few people had expected.

Having said all this, the market’s reaction still seems rather excessive. The key message from the March meeting was that the Fed now sees inflation as having essentially reached its 2% target. This was reflected in the decision to strip the reference to the “current shortfall of inflation” from the statement. As far as the reference to the Fed’s “symmetric” target is concerned, this is something that Chair Yellen and other FOMC officials have stressed many times before. All it means is that the Fed will not react too aggressively if core inflation were to drift somewhat above 2%. It does not mean that the Fed will purposely try to engineer an inflation overshoot. If it had wanted to do that, it would have lifted its 2019 inflation forecast. It didn’t do that; it remains stuck at 2%.

Why then did the FOMC bothered massaging the language? The answer is that the Fed was probably worried about destabilizing markets. After all, investors were pricing in only a small probability of a March hike just a few weeks ago. A “hawkish hike” could have caused markets to rethink their view that the Fed will “take it slow”. However, now that financial conditions have eased sharply in response to the FOMC’s decision, it is likely that Fed speeches will lean in a more hawkish direction over the coming weeks if the economic data come in firm. Our bond strategists recommend maintaining a below-benchmark duration stance.

EM Growth Scare Before Year End?

If EM/China credit growth decelerates, it will not only cap inflation but also cause a growth scare.


Given China’s onshore corporate bonds rallied dramatically in 2015-16 on the back of massive investor-buying, a further drop in these bond prices might trigger an exodus of funds and a meaningful push-up in corporate bond yields. In fact, the price of onshore corporate bonds continues to make new lows, and is already down 8% from its peak in November 2015. This could cause corporate bond issuance and other non-bank financing to slump at time when bank loan growth is already decelerating.

Ultimately, higher borrowing costs along with regulatory tightening of banks’ off-balance-sheet operations may cause a slowdown in China’s domestic credit flows in the second half of 2017. This could spill over to other EM economies due to lower mainland imports and declining commodities prices.

In addition, the banking systems in many EMs have not adjusted following the credit boom of the preceding years. Unhealthy banking systems and higher global interest rates will cause further retrenchment in domestic credit creation.

Bottom Line: A renewed slump in China/EM growth later this year will warrant an underweight position in EM risk assets across equities, credit and currencies according to our EM strategists.