On Monday, Trump officially went through with the 10% tariffs on $200 billion worth of Chinese goods (announced this summer) and China retaliated by slapping new tariffs of 5%-10% on $60 billion worth of American goods, as promised. Arguably, they were a lot less than the level China threatened to do so over the summer, and Trump held off on the 25% level until the beginning of next year.
However, on a day when both sides showed no sign of standing down, one would expect to see the dollar rally aggressively, yuan tumble, and emerging markets (EM) take another leg lower. Low and behold, risk assets rallied, dollar fell, commodities were up 2% and base metal stocks were up 4% on average. What gives? When additional negative headlines fail to take the market down or the dollar higher, it can only mean one thing, that trade tension is already more than priced in. The pain trade seems to be higher, not lower from here.
According to the Bank of America Merrill Lynch Fund Manager Survey for September, U.S. equity allocations rose 2%, to 21% -- the highest level since January 2015 -- making the U.S. the most-favoured region globally. Allocations to emerging markets fell 9% to 10% underweight, the lowest level since March 2016 -- a massive u-turn from April 2018, when investors were overweight 43%.
To put it in layman's terms, investors could not be more long U.S. over short emerging markets. And 24% of investors surveyed expect global growth to slow down in the next year. This is the highest number of pessimists expecting a worse outlook on the global economy since December 2011!
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The contrarian in me can't help but think that what can surprise markets is a rally in EM here, relatively, not a fall in developed markets (DM) outright. Most are playing short the U.S. market via short S&P 500 futures, as the market that has outperformed the most. But what can surprise them perhaps is that the S&P can continue to grind higher as economics are robust and balance sheets healthy, but select emerging markets can rally even harder, and no one is positioned for it. Ouch.
According to this most recent survey, investors are long U.S./cash/REIT/U.S. and underweight EM/UK/Materials/Energy. The Federal Reserve holds its key two-day policy meeting on Sept. 26 -- and a rate rise for September is more than priced in. The issue at hand is what happens in December and in 2019.
Fed Powell's comments at Jackson Hole indicating inflation was not at risk of overheating suggests that perhaps their "gradual rate hike" mode can come to a slight pause. If any hints to that effect are made, the dollar will have a nasty fall, as everyone rushes for the exit.
The U.S.-over-EM trade made fundamental sense as U.S. rates rose and EM markets faced higher debt service costs, given their dollar-denominated debt. But the extreme selloff across all risk assets and cyclical stocks in August, as everyone claimed Chinese recession and global growth was falling off a cliff, caused a rather dramatic selloff outside of fundamentals -- especially in markets like Copper, Nickel, Steel and Iron Ore, where premiums are trading at highs and markets are tight. But the perception of these commodities being linked to the Chinese economic cycle made them victims during the harsh selloff.
It is time to put psychology behind and analyze the fundamentals. Solid copper and base metal companies, with high cash flow and stable pricing, have fallen more than 20% for no reason -- despite no change to the outlook other than worrying about collapsing EM markets. Markets such as Argentina, South Africa and Turkey have systemic issues, but China and other select EM regions have much-better fundamentals and stable FX reserves.
Watch the dollar, as that has, and will, dictate all asset classes and sector allocations. Also, over the past month, China has been boosting stimulus and credit in the background, but no one has noticed. Don't be too bearish on the red dragon just yet; they have mastered the art of surprising us all when we least expect it.
