SocGen Thinks Emerging Markets Are Breaking Down: Here's Why

With Goldman Sachs publishing at least one, and in most cases two or more weekly reports urging its clients to keep pouring capital into emerging market assets, whether equities, bonds or FX, it is no surprise that Emerging Markets remain the big winners in 2017, up 10% points more than developed this year.

However, as SocGen's Andrew Lapthorne cautions this morning, signs of weakness are starting to appear. The first indication that the party may be ending is that the MSCI EM was down 50bps last week, having fallen over 3% the week before and as we show below EM has broken its 2107 upward trend. Conversely, as Albert Edwards indicated this morning, the 14-week RSI on the S&P 500 is above 81 and hasn't been this high since 1995.

What is the connection between EM vs DM returns? It is hardly a secret that driving the EM versus DM performance in 2017, has been the weak US dollar. Andrew Lapthrone notes that this can be shown by comparing an equal-weighted developed market index in local currency terms against an equivalent index for emerging markets.

As we show that there is little difference between the two and also shows evolving weakness in EM recently. Incidentally these equal-weighted indices somewhat refute the idea that equity market performance this year has been highly concentrated as these indices remove both market cap and sector effects.

But what is the catalyst behind this selloff? As SocGen's Puneet Singh has been highlighting in recent days, much of the weakness has stemmed from a sell-off in companies with the poorest balance sheets. These typically lower quality stocks (as measured by Merton's distance to default) had been performing strongly for most of this year, having at one stage been up by 30%, ytd (in contrast to their weakness in the US), but have now fallen 8% in a month.

Lapthorne's conclusion: "This is hardly a disaster yet, but with balance sheet related problems and events becoming more common across the newswires, this is certainly one to watch, as stronger (or indeed no longer falling) US dollar and Emerging Market debt problems often go hand in hand."