A monetary ‘flywheel’ in reverse. Asia / EMs should outperform the US.
“Identify the paradigm you’re in, examine if and how it is unsustainable, and visualize how the paradigm shift will transpire when that which is unsustainable stops.” - Ray Dalio
The conditions brought about by the past decade’s quantitative easing cannot persist indefinitely. According to one estimate, each $1 in central bank asset purchases might add $0.20 to economic output (GDP), but it has 10x that impact on the stock market. So as Fed intends to reduce its balance sheet by 15% of GDP and raise interest rates along side, one might imagine a 30% decline in US equity multiples using the math above. We have already seen some of this decline.
To put this into some context, the US equity market is valued in excess of 200% of GDP — materially higher than was the case in 1999 (153%) and 1929 (118%) or Japan was in 1989 (140%). A rising tide of financial wealth has translated, modestly, into higher consumption. A convincing account recently put this ‘beta’ at 0.03x, i.e. $1 of increased financial wealth leads to 3c of higher spending. George Soros would call this a “reflexive” process where markets can influence the fundamentals they are trying to anticipate.
A simplified heuristic (below) would suggest that the US is much more vulnerable given the relative starting positions and inflation levels, corresponding to the need to tighten.
Source: BIS
If the Federal Reserve does not sufficiently tighten and inflation remains persistently higher than in other countries, the currency would over time become uncompetitive and overvalued. On a real-effective exchange rate basis (a measure of relative currency valuation), the dollar is at the upper-end of a well defined trend (defined as +/- 2 sigma) that has been in place since the mid-1960’s. An overvalued currency will become an issue for attracting capital flows to U.S. treasuries (and other assets), where foreigners are already very overweight US financial assets and where domestic savings rates are insufficient to fund the structural fiscal deficit (3-4% of GDP p.a.). This problem of attracting capital flows has become more acute. A recent Fed paper highlights significantly reduced “flight to safety demand” for USTs during periods of financial stress.
Chart 1. Source: “Foreign Effects of Higher U.S. Interest Rates”. Iacoviello, Matteo and Gaston Navarro, 2019.
Clearly, the idea that EM’s could outperform the US during a tightening cycle goes against the received wisdom. Historically, EM’s slow more than Advanced Economies, including the U.S., during these periods (chart 1, right).
Yet a closer inspection reveals this to be very situation-dependent. EMs with higher foreign reserves, lower external debt, and lower levels of inflation actually fare better than the US during a monetary tightening by the Fed (chart 2, below).
Chart 2. Source: “Foreign Effects of Higher U.S. Interest Rates”. Iacoviello, Matteo and Gaston Navarro, 2019.
Today, EMs are much more resilient than in past cycles with improved current accounts balances, less external debt, a less cyclical composition of equity sectors, and stronger trade relationships with China than the US.
Some historical perspective — reconstructing an EM equity index back to 1970s highlights a few salient points.
(1) Changes in the value of the dollar is strongly linked to the relative performance of EM equity markets. This factor is clearly the “wild-card”, but historically the dollar weakens after the first Fed funds rate hike. Moreover, unlike much of financial history, it is the U.S. rather than EM economies that require continuous capital flows amidst tepid demand.
1970 to 1980: Weighted index of HK, India, South Africa and Mexico. 1980 to 1987: HK, Korea, India, South Africa, Mexico, Malaysia, Israel. From 1987: MSCI EM Index. Sources: OECD, St Louis Federal Reserve, FXTop (historical FX rates), Stooq.com, World Bank.
(2) Markets prices move on a “rate of change” basis. As GDP growth moves in favor of EM economies, the stock markets outperform. It is not as much about the absolute levels but the change in direction.
Let’s see.
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