Thursday, May 16th, 2019

Show Me the Damage

You have to look quite carefully to find the impact of the US/China trade dispute in the equity markets of those two countries. Yes, both of them sold off suddenly as they reacted to President Trump’s barrage of tweets, but the response was within the normal level of volatility for each index. Our sector model for the US only shows a slight dip in the recommended weighting of Technology and Industrials, the two sectors held to be most at risk from a trade war, Since March, there has been a gentle downtrend in our recommendation for Chinese Industrials, but they are still slightly above benchmark weight. There is weakness in Materials, but this is typical of the whole period from 2008 onwards.

Financials in both regions are doing well. They are #1 in China and almost unnaturally stable. The sector in the US is much lower ranked but has been trending higher since March and was recently upgraded to neutral. This is not the reaction of sectors where there is going to be significant increase in financial stress. The Chinese are clearly programmed to support their financial system in the event of what they see as an attack from foreign interests. The US authorities don’t think there is a significant risk to their equity market but have also confirmed that they would cut rates if one developed.

So, show me the damage. Actually, it’s not difficult to find. It’s all over EM equities. In our regional equity model, we downgraded them to neutral this week, but this is just a stage in a process which started when the region peaked in early March. Of course, some countries are more affected than others, but it has been a broad-based retreat, which started several weeks before the sell-off in China. Only Taiwan has been relatively unaffected. Otherwise, the region is falling fast and has no obvious support level until it reaches a substantial underweight.

The Emerging Market decline is expressed in two forms: currency and equity. The most visible part is the relative performance of equities. The currency dynamic is more dangerous in the long run. Excluding China, which has a managed exchange rate, the volatility of a basket of EM currencies is the lowest it has been for the last two years. It may even fall further once the Indian elections are over. But after that it is difficult to see how it can go much lower. Meanwhile the volatility of basket of DM currencies is already 70% of its 24-year median – the lowest ever reading apart from the aftermath of the euro crisis in 2013.

There is a strong and unsurprising relationship between volatility in currencies and other financial assets. It has actually deteriorated since President Trump was inaugurated.  In 2017, financial market volatility was lower than expected in relation to currency volatility. For holders of financial assets this was a benign regime, but from early 2018 financial asset volatility is higher than we would expect. The danger now is that a material increase in FX volatility in EM currencies could trigger an expectation of higher volatility in DM currency markets which would become self-feeding. Currency volatility in developed markets would then affect other financial markets and the willingness of investors to continue holding risk assets. If you think that certain EM countries will respond to equity market weakness by allowing their currencies to slide, you should be aware of the implications for DM currency volatility and financial markets in general.

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