EMD Relative weekly notes
Week Ending June 23, 2017
Last week's Fed rate hike is being treated by markets as part of a prematurely hawkish stance that has a high probability of being reversed or abandoned from our perspective. We view it as the difference between theory--that inflation should rise with low unemployment, which the Fed clings to like a life raft--and reality--that inflation and wages show no signs of structurally rising. How this is resolved will tell us a lot about how emerging markets will do in the second half of the year.
As always, the US dollar is key. It rose by just over 1% to end last week following the hike, but this week re-traced half of that gain--presumably as the market began to judge that the continuing flow of economic data did not support a more hawkish Fed. The local currency index wiped out about a 1% gain for the month during this period, but in concert with the weaker dollar recovered some of those losses in the last two days of this week.
One of the things that helped to keep the dollar's rise subdued has been the continuing steady flattening of the yield curve in the US, which seems to indicate considerable skepticism in the market about the Fed's view of the economy’s outlook. Since the Fed decision, the US long bond has fallen in yield by 12 basis points.
We would be the first to say that if the Fed's theory turns out to be correct, and multiple additional hikes are to follow in the next 18 months, that that is a negative scenario for emerging markets. That development would risk a stronger dollar that would draw liquidity from the asset class. If the markets are correct in their assessment as demonstrated by key asset price moves, however, we believe we should see a continued benign risk environment for EM.
One final caveat to an “all-clear” signal for EM, however, is commodity (and specifically oil price) signals. A downward trend in prices was already apparent pre-Fed move, though it quickened post-Fed as oil fell an additional $3 per barrel. Even there, towards the end of the week oil seemed to find a tentative floor and regained a third of that loss.
We are no better than all of the other failed oil forecasters in the market, but we would opine that a further sharp fall would probably require a significant amount of more negative news, presumably on demand as well as supply. The chart below shows that the rate of growth in US rig counts seems to be slowing as prices fall. That suggests that the cure for the fall in prices is the lower prices themselves, and a palliative to that trend is already starting, albeit slowly.
Source: Bloomberg, Baker Hughes; data as of June 23, 2017
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