Emerging markets are down 15% since highs reached earlier this year, while the S&P 500 is flirting with its highs of the year. The world is moving away from globalization, as President Trump makes America an isolated country protecting its own interests. Even so, it still needs -- and trades with -- the rest of the world. We do not move from globally synced to totally isolated in six months!
Plotting a chart showing the economic data change correlation of the U.S. vs. rest of the world shows it just hit an all time low, suggesting the U.S. is growing, and can continue to grow, at a 4% rate without any help from the rest of the world. But these things take time, and in the meantime, if demand from emerging markets collapses and trade volumes fall, the U.S. will get hit too -- unless Trump thinks he is one of the Fantastic Four characters with a secret shield on the U.S. economy.
Looking at asset allocation charts in the Bank of America Merrill Lynch Fund Manager Survey, allocations to emerging markets have fallen relative to developed markets, no doubt, but they are still a bit above the lows hit back during the global financial crisis in 2008. It would suggest there is some more room on the downside? However, looking at the valuations of EM vs. DM, there is no doubt that we have hit a low going back many years.
So who is right? Well something has to give. Either analysts are way behind the curve on their EM/DM valuations and the "earnings" are all wrong, or the global economic data needs to improve. These divergences do happen from time to time for a few months, but economically they cannot exist for too long without contagion in all parts of the world.
Last night the euro rallied 100 bps vs. the dollar. That is an unusually big move for a developed market currency pair. What is going on? If you look back this month, the dollar has actually been weakening against some developed market currencies like the euro and Aussie dollar, and this is apparent in the pullback in the famous DXY index as well.
U.S. bonds have rallied over the last few weeks as 10-year yields have moved from 2.9% down to 2.8% now. This should have been helping the EM over DM trade, but it has not -- perhaps due to lack of belief. Remember, there is the mother of all shorts in U.S. treasury markets and a long in USD positioning. Who is the marginal buyer here for the USD? We all know it makes sense, its played out, but someone buying it here has got to ask the question, am I late to the party?
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Clearly Trump has thrown the blame on the Fed for being unfair and "raising rates" in this environment. The Fed faces a very delicate task to fine tune messaging into this week. If Powell decides to be an economist and delivers a hawkish tone, the USD will rally probably a few percent, but EM markets will collapse. The U.S. market better watch out, as now it is crunch time: The U.S. market will be taken down too. And Fed's Powell will be labelled as the man single-handedly responsible for causing the collapse.
It would be wise for the Fed's Powell to tread carefully and be diplomatic, perhaps even slightly dovish, to save his job and buy him some time to see how things develop. It would be career suicide otherwise. The market just needs to hear a bit of support, it does not need to actually get it, to find some support here. But if Powell decides to take on Trump as Trump did with China, then unfortunately this can turn very nasty for everyone.
But then again these days, it is not about economics or the greater good. It seems a few at the very top have a personal agenda -- and they are taking us all down with it. Trading was so much easier in the 1990s, when capital markets theory 101 actually worked.