What Can Kill The S&P; What Can Save EMs; Just Two Things

While emerging markets recently tumbled into a bear market, the US stock market continues to surge, defying all fears of a Chinese slowdown, a global trade war, and peak earnings. But why? As Macquarie strategist Viktor Shvets writes this morning, US resilience is due to its role as the largest supplier of end-user demand, printer of reserve currency, and quality of its corporates. Meanwhile, EMs are an artefact of global forces, and of Chinese cooperation with the US. As a result, for synchronized growth one needs liquidity, trade and reflation. According to Shvets, these three are possible only when the US & China cooperate. He notes that "we are not there yet."

Below we share more details from Shvets on the most vexing divergence of 2018:

Why are US markets so resilient? Three reasons:

One of the more popular questions that clients asked us recently is why are US equity markets so resilient and when do we think EMs might break out from their bear market trajectory? US resilience is based on three factors.

  • First, US’s role as the single-largest pool of global end-user demand. Unlike Eurozone and Japan that are essentially riding China’s reflationary waves, the US (Anglo-Saxons, in general) are the only generators of sustainably high deficits. The US is the other side of excessive savings in the rest of the world.
  • Second, US$ role as the global reserve currency. While over the longer term, it is not good for anybody, in the short-to-medium term, it offers the US massive advantage in attracting capital and using it as a lever in negotiations.
  • Third, quality of US corporates. More than any other region, the US corporate sector embraced arbitrage opportunities that have become available over the last three decades in global product, labour & capital markets. Consequently, they are asset-light and cash-generative, which explains SPX strength.

EMs performance needs specific outcomes

EMs on the other hand are a tentative future promise but not yet a delivery and they need abundant liquidity, low volatilities, free trade and global reflationary momentum to prosper. While most of these conditions were in place in 2016-17, this has not been the case through 2018. EMs as an investable concept is an artefact of globalization, generally weaker US$ over long stretches for the last three decades as well as rapid global financialization, which lubricated trade and domestic consumption while drastically reducing cost of capital.

However, the global economy is now in a deglobalization phase, as the only strategy to reconcile political dilemma of the world (nation states, local politics and globalization are not compatible), while manufacturing is no longer the king’s road for EM convergence (due mostly to rapid changes in how products are manufactured and traded).

At the same time, CBs are determined to drain liquidity (mostly US$ liquidity, as the Fed ‘burns’ US$50bn per month) while raising cost of capital. We are also seeing the single-most important supplier of demand and printer of global currency (US) refusing to perform its role of lubricating global demand and liquidity.

Only possible when China & US cooperate. Watch US$ & Trade

It is only reversal of these fundamental factors that would get EM equities out of the bear market trajectory. However, to achieve it we need to have a close cooperation between US and China. US determines global liquidity and cost of capital while also providing end-user demand, while China is able to reflate global economy through its intensive commodity & investment business model, sheltered behind capital controls.

We maintain that only severe domestic pain would change the US narrative. The easiest way to see how it might happen is if the US$ massively overshoots, and then blows back via various transmission mechanisms (from liquidity to SPX EPS growth rates). At that point, Trump, the Fed and China would be on the same page. We are not there yet.