It's Goin' Down In The DM, Hit Me Up On The EM


Quick update on DM and EM divergence today. I know it has been a well-documented topic for the last few years, but wanted to point to people's attention again, as I feel like we are close to the precipice for a reversal.


I'm sure Bloomberg has shown this chart in the past in its regularly scheduled programming. But digging into the fundamentals, things become even more eye opening.

A quick look at fundamentals, obviously EM is cheap - I picked a few indices that generally people put in "EM" and "DM" buckets. For the most part, DM is expensive. For the most part, EM feels cheap. Valuation below - (by the way, Eurostoxx was used for Europe, FYI)



I'm sure we've all seen US equity and growth divergence charts on Zerohedge.com. I wanted to dig deeper myself, to look at the differences between EM (MXEF as the proxy) vs DM (US/SPX as the proxy) in terms of growth vs equity performance.


Despite EM outgrowing DM - the underperformance has been palpable.


Please mind the gap. The divergence has been evident, yet it seems to be bottoming. I hate to bring everything back to Trump but I think that will be the catalyst. 

Remember from the last post, trades go in and out of favor. The EM trade has been out of favor for 7 years. The Trump trade has been 7 weeks. Both of which might be making a resurgence soon. 



Yo Gotti knows it's going down in the DM. 

But, but, but, but...Protectionism and other Trump stuff!

Well, interestingly, after all the populist rhetoric, EM equities have actually outperformed DM in 2017 YTD.  EM currencies have been ripping as well against the dollar during the same period

There could be a few reasons why that's happened. Inflationary pressures can be good for EM exporters and can temporarily soften any blows from protectionism.  Additionally, the potential lack of access to the US and other DM can lead to meaningful reform in emerging economies. The world runs on unintended consequences. 

Trump's actions can unintentionally manifest as incentives for EM to take on reforms that will drive wage growth, productivity growth and domestic consumption that ultimately leads to economic resilience. 

A number of EMs are in crisis/post-crisis mode, where their domestic issues are being aggressively addressed (Brazil, Turkey, Argentina, and Russia come to mind). That seems to be a sign for contrarian investors to start building stakes. Although I like most EMs, a caveat must be noted. 

There should be a distinction made between good and bad EMs. Zuma's debacle that is South Africa - bad EM. Real reform and progress made in Argentina - good EM.


As always, good luck out there.




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Nico G
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April 20, 2017 at 10:30 PM ×

normally the distinction between good and bad EMs is made after the facts when you're left with $$$ or a huge loss

i remember how all things Brazilian and Turkish were everybody's darling in 2012

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April 20, 2017 at 11:01 PM ×

Apologies but im confused. Are you saying this year's EM outperformance reverses due to upcoming Trump protectionist measures?

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johno
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April 21, 2017 at 2:47 AM ×

We're coming up on an event that probably gives markets new impetus, if not starting 4/23, then 5/7. I think, just as with the US presidential election, we're probably not as focused as we should be on that other economy that matters -- China. From what I can tell, private credit demand is still there (to buy property), which should be bullish for commodities. Meanwhile, commodity markets got washed out, catalyzed by the inter-bank rate squeeze. I wouldn't be surprised to see copper ripping higher coming out of a benign election result, just as we saw following the US election.

The EURUSD has been trading closely with the bund-treasury bond spread, so I'd expect a positive election outcome to have people calling the end of the dollar bull market (EUR is a large part of DXY, so the latter is going to crash through those DXY support levels the technicians talk about). I have a ton of OTM EURUSD (and TRYUSD) upside through options so I won't panic into selling USDs then (I have a terrible dread of missing the turn in the dollar). The USD might not be so bad after the dust settles. Q2 will likely see a pickup from Q1 (the usual data seasonality of past years), a hike comes in June, and rate shorts could re-build. That said, I expect the next Eurozone inflation print to be good, thanks to reversal of German travel package distortions.

Oil is interesting. Saudi will extend and the gasoline stocks build was possibly an aberration, according to GS (who back out implied gasoline from ethanol #s and assumed blend rates with results that fit the monthly data better than the weekly gasoline #s). CAD and NOK both look interesting to me here.

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Detroit Red
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April 21, 2017 at 3:03 AM ×

Re: Mariusz Banasiak

Sorry for the confusion - I guess I was pretty vague.

So EM has underperformed DM for years despite a divergence in growth - more EM growth than that of DM. I think that trend will reverse and you will see EM outperformance going forward in the near future.

Why now?

I think it's really peculiar that EM has outperformed DM in 2017. I remember when Trump was first elected, EEM fell off a cliff while Spoos ripped - big time divergence. However, this year (2017), EM has steadily climbed relative to its DM peers. I pondered why that was the case and came up with some reasons in the post above.

I think this is a strong signal - in my experience when the entire market expects something (and that something is very intuitive) - Trump/protectionism kills trade and thus emerging markets and the opposite happens in price action, then there's something materially strong going on there.


Does that help explain things?

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Eddie
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April 21, 2017 at 1:32 PM ×

Leaving technicals aside, do you have an idea why EM underperformed DM despite growing way stronger? My naive guess would be that this something has to change to close the gap. After all it lasted seven years.

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johno
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April 21, 2017 at 2:42 PM ×

I think I've seen studies showing EM out-performance endures where growth differentials to DM get wide enough. I'm not sure they're wide enough now to make one comfortable owning EM medium-term. In the near-term, I think they're largely a game of surprises relative to economic growth expectations. Could be interesting to see how they track forecast revisions, for example, found with ECFC function on BBG.

I contend that the big driver of the global real economy (and EM) is China, and of global financial conditions is US monetary policy (which is a function of US economy, which in turn is increasingly a function of China). In China you have a boom in private investment driven by leveraging of household balance sheets (last reported quarter corporate leverage-to-GDP actually fell!). Those households have room to lever up (half the leverage of US households), but my guess is Chinese growth is going to slow once we get past the 19th National Congress where Xi consolidates power for the next 5 years.

I was interested to see Vinay Pande writing for a column in the FT the other day. Smart dude, from my experience. Interesting to see him using ERP arguments for being long stocks. Anyway, I was struck by this stat he mentioned: "Globally UBS Wealth Management’s private clients hold an average of 25 per cent of portfolios in cash, rising to 30 per cent for ultra-wealthy individuals." Makes me think there's plenty of upside risk to equities, but my guess is it would take inflation plus central banks deliberately falling behind the curve, precipitating angst that "those bastards are going to let inflation eat my cash pile so I'd better buy shares of Campbell Soup and/or gold."

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fwdem
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April 21, 2017 at 2:49 PM ×

Looking at GDP growth rates might be misleading in this context, EM might well have outgrown US in real terms, but looking at nominal $ terms the picture will differ, hence it would be better to plot nominal EM vs nominal US GDP, I assume much of the gap would disappear.

We know that EM P/E are well lower than in DM, they always have and always wil be. MXEF almost closed the gap to SPX in 2008, I didn't run the numbers, but my feeling is that the convergence was much more driven by the commodities super-cycle, leading both P and E up, not necessary due to a rise of the P/E ratio.

Re bullish Turkey, the country run a current account deficit at 120 $/BBL, it still runs one with 40 $/BBL, something must be seriously broken, the demographics might be favorable, but on that metric alone there are more promising opportunities.

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Leftback
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April 21, 2017 at 2:51 PM ×

Fixed income punters are buying the dip this morning.

LB has learned not to discount the possibility of an irrational election outcome. It's unlikely that all the Raving Loony candidates will be eliminated in the first round of the French election. The weakness of Fillon, due to his legal issues and association with Sarko, is really going to be a factor in assisting the "fringe" candidates - from the left and the right. This is very reminiscent of the problems with HRC, the centrists had to hold their nose to vote for her, and the left and the young stayed home instead. The best guess here is that the first round will be frightening, but the French will not actually go full retard in the second round.

Interesting on EMs. That thesis works well if the dollar falls, as it may do in 2017, but doesn't go anywhere if China stalls. An EM v DM trade may end up working, if only in the sense that "EMs fall less far than DMs b/c less over-valued".

EM bonds have been a really good story of late and may continue to work.

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fwdem
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April 21, 2017 at 3:00 PM ×

hence it would be better to plot nominal EM vs nominal US GDP meant to say- hence it would be better to plot $ nominal EM GDP vs nominal US GDP

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Nico G
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April 21, 2017 at 3:55 PM ×

johno

have you seen China corporate yield progression since November?

AA+ shot from 3.3 to 5% you can expect liquidity problems hitting the news soon

LB

congratulations on your bond trading. I do expect French to go not full retard, but fully scared in the second round.

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Leftback
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April 21, 2017 at 4:37 PM ×

Crude has just broken below $50 this morning… looks like that level isn't going to hold much longer. Yields will follow.

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checkmate
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April 21, 2017 at 4:53 PM ×

The post crash risk rally as been the most hated in my lifetime. I suspect most of that is recency combined with a mistrust of a market so seemingly dependent on central bank policy. I would go so far as to say I don't think that really changed until last year when apparently so many decided that Trump inspired growth meant the central bank policy would not be the sole driving factor in market health. Bear with me here. The connection to EM underperformance is in my view that lack of trust, lack of confidence which will have been reflected in portfolio allocations where liquidity is more valued than growth rate data. There may even be an element of demographics involved. Older generation investors have first of all been looking for yield not growth and again if their investments reflect that it explains much of the performance in bond markets vis a vis EM equity . Assume I am concluding this is a combination of psychology ,liquidity and the demographics of the investment community.

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abee crombie
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April 21, 2017 at 4:55 PM ×

Nice post detroit Red.

Johno, do you really see commodities rallying from here? I think that ship has sailed. I am cautious on most at these levels given the fundamental over supply in many individual markets.

They went totally bonkers on china re-stocking, thats all. Now back to reality. Oil though might push up to high 60 in second half of year as the real economies of many EMs/EU are doing very well. But IMO, this is a last grasp. Leading indicators, PMI/ISM looked to have topped out and I think commodity prices with them.

Meanwhile US markets in lala land still, with big tech seemingly doing no wrong.

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eruditetroll
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April 21, 2017 at 5:03 PM ×

Have to split this into two parts.

First, let me reply to this.

NG: there is a risk of a -4% gap anytime.

ET: Another story from the past. In December 1999, the Nasdaq Composite crossed 4000 for the first time. I told everybody who would listen that it was going back to 1800. It ended up falling all the way to 1108, but it went to 5132 first. And it took thrity-one months to fall from 5132 to 1108, so there was plenty of time to get on board. I am not worried about missing the first four percent of a protracted decline. Of course, I want to catch as much of it as I can, but I won't be able to time the top better than anyone else, so I am directing my efforts to recognizing a top as soon as possible after it happens, but not trying to anticipate it.

I agree with every reason you give (and more) about why the market should go down. But ( after the last eight years), I won't believe it until I see it.

NG: Would you ET, short a 4% gap hole? i don't think so

ET: I follow my process - when it says sell, I sell, and when it says buy, I buy. I concede that putting on shorts after market drops has not worked out too well recently, but it will eventually be quite rewarding again.

NG: it can happen on Monday. It can happen after 2500. Or 2600. I am in a challenging position, with a 2300 average. But mentally i feel privileged to have made up my mind and paid to play.

ET: My biggest question regarding your strategy is that it appears you are trying to make a quick five percent, but the market could rally another ten percent before a sharp break comes.

NG: PS: your pre FOMC trade didnt pay much. This market is exhausted.

ET: Obviously, I can't attack your opinions, but with regards to actual facts, let me just say "YOU ARE WRONG!" ESM7 closed at 2363.50 on 0314 (and opened there on 0315). It closed at 2379.25 on 0315 (Fed day). You have very high standards if you think that fifteen plus S&P points is not a reasonable payoff for a one day trade (I would be quite happy with that any day).

I will add that the beloved founder of this community just happened to write about this trade a week later. Zerohedge was kind enough to post the note (for those who don't have access to a Bloomberg terminal) here. As you may surmise from the headline, he thinks being long on FOMC days is quite worthwhile.

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eruditetroll
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April 21, 2017 at 5:04 PM ×

Also, from that thread. Johno, one of the reasons I like vix futures is I get paid for being patient (meaning when nothing much is happening), which is not my natural inclination. I always tell people "it's easy to make a huge amount of money just shorting vix futures, but it's difficult to keep it." The ultimate profitability depends on managing the spikes. Sometimes I do a great job with those (Brexit), and sometimes not so great (Trump's election). To follow up, the March expiration did not go well (from 11.60 to 12.15 on the last full trading day), but when March became the front month it was at 12.30, so still on the correct side of the ledger, but most of the month's profit vanished at the end. I started April short only 100, which quickly became 50, and then flat. For a brief while, I was even on the unnatural (long) side of vix futures, but it looks like the spike is over (that spike, there can always be more spikes, of course, and I have no idea how the game of chicken known as the debt ceiling - and more important, the market's reaction to it, will play out). So back to short (fewer than 100 at the present time). I am actually hoping for a much bigger spike soon to eventually restore the steepness of the term structure, which has become so compressed (December at 16.80 as I type this) that there simply isn't as much room for the futures to fall relative to spot as there has been over the past few years, which limits the profitability of the trade.

Moving on to the French election, I basically see two market-unfriendly surprises - one, Le Pen runs away with it (say getting more than thirty percent of the vote), which sets her up well for the second round, and two, Melenchon and Le Pen advance to the second round. I think there might be some overlap in terms of supporters (Why is Le Pen always described as "far right?" Her economic policies are WAY to the left of Bernie Sanders), basically votes against the current establishment, so I consider this possible, but not likely. There are also two market-friendly surprises - first, Le Pen doesn't advance to the final (I consider that quite unlikely, though also possible), and second, she loses the first round. I don't consider that the most likely outcome, but I believe it is priced in much less than its likelihood of occurring. Therefore, at the risk of looking foolish yet again, I have spent the past few days trying to position myself away from the crowd (covering copper shorts, buying equities, selling vix, gold, bond, and eurodollar futures), all of which I might very well reverse after the first round results. I really have no clue on the euro, it is a funding currency, so the decrease (or increase) of its use in carry trades would offset some (most?, all?, more than all?) of the fundamental weakness (or strength) as indicated by the election results. Anyway, to summarize, if Le Pen looks week, there could be a sharp (if brief) risk rally that I don't think people are prepared for.

Finally, to comment briefly on this post, certainly the relative value of emerging markets has been improving relative to developed markets for the past several years (long way of simply saying that they have underperformed). I still have a lot of concerns about debt levels - and not just in emerging markets (including the scenario that the Fed hikes to the moon and blows up all of the EM dollar denominated debt). The credit cycle hasn't even begun its completion phase (many years after the crisis). However, most still-developing economies still make things (instead of just shuffling money around), and one could actually argue that many of those governments are better run than the governments of developed economies, who seem to expend ever more effort to interfere with markets (and, at least temporarily, succeeding at it), so advantage EMs (at least in terms of relative performance - don't like equities at all in the meduim term) going forward.

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AB
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April 21, 2017 at 7:00 PM ×

Have a look at EM earnings and earnings growth vs. DM. Stocks are not GDP warrants.

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Skr
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April 21, 2017 at 7:12 PM ×

Try explaining what a safe haven is to an algorithm, and I dare say it would shrug its shoulders if it could.
While the DM V EM Spread trade is of interest as is Mr bond, is it too simplistic to argue that the Oil/Dollar spread trade is still king and everything else is a by product so to speak.

This is to provoke thought - not contributers.

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Leftback
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April 21, 2017 at 9:25 PM ×

Italy downgraded to BBB. Guess BTPs aren't going to be a "safe haven" for ever… :-)

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IPA
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April 21, 2017 at 11:48 PM ×

abee, I knew we would agree on something one day :) Ditto on everything you said. Picked up some XOP & XLE today. Need to let OIH figure out if it wants to play or sit in the corner, but mostly SLB and HAL related weakness here, watching it...

Big tech may be ready to crap too, check out possible head and shoulders action on NDX. We'll know what to do early next week. Abyss below 5300. This being said, PTJ thinks Nasdaq makes new high before it's all over. Can't argue with him, my idol.

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Gus
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April 22, 2017 at 4:32 AM ×

https://www.bloomberg.com/news/articles/2017-04-21/analyst-who-predicted-trump-ascendancy-is-betting-on-le-pen-win

Charles Gave, founder of Hong-Kong based asset-allocation consultancy GaveKal Research and who predicted the triumph of Donald Trump in the U.S. election, is now betting on a win for the anti-euro National Front candidate.

“Le Pen’s momentum is a slow-moving reaction against the men of Davos -- as we have seen with Brexit and Trump -- but markets don’t want to believe it,” he said by phone before the first round of the French poll on April 23.

Given the prospect of a Le Pen victory, Gave, who has been researching tactical asset allocation for more than 40 years, is advising clients to adopt long positioning in the pound as the U.K. would benefit from haven bids, and shorts on inflation-linked German bonds amid the risk of deflation in the euro area.

The French economist also recommends bets on the likely outperformance of publicly-listed European multinationals, given their outsize share of income in foreign currencies. In effect, for investors obliged to invest liquidity in euros, Gave says a basket of high-quality stocks is a safer bet than euro-denominated government bonds.

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checkmate
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April 22, 2017 at 7:45 AM ×

This election may at least resolve one issue that remains under question after the UK referendum and the US elections. Are the pollsters actually picking up that segment of voters who will not disclose their true intentions because they perceive them to be socially sensitive. We are talking about those former moderate voters who are acting out of character by making what they feel to be an extreme choice. I have thought that the tight contests both in the UK and US may have been decided by this group and given the margins that separate the candidates in France I wonder again if they will be the overlooked wild card.

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MacroWatcher
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April 22, 2017 at 2:55 PM ×

Read this interesting article on using social media data and the guy's data seemed to favour a LePen/Melenchon showdown : https://antoinebevort.blogspot.pt/2017/04/french-presidential-election-scope-and.html . It is interesting since it seems to have captured both Fillon and Hamon recent wins in their parties election.

Ran some numbers and using Alexa pageviews data , Macron is clearly above all else and Melenchon was leading until very recently. LePen is slightly ahead for now.

http://imgur.com/a/nyPok -- uses 20d median of pageviews but shorter window paints similar picture. Didn't use rankings data because LePen has two main websites ( frontnational and marine2017) so individual ranks won't work.

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IPA
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April 22, 2017 at 8:29 PM ×

Peter cries wolf again. I think Mr. Market is done with Trump. Time to "massively" sell everything he says, without exception.

https://www.washingtonpost.com/amphtml/news/wonk/wp/2017/04/21/the-white-house-reveals-what-next-weeks-big-announcement-on-taxes-will-look-like/

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checkmate
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April 23, 2017 at 8:08 AM ×

I'm not sure why you link that conclusions and that piece. The piece itself in my view is no more than one of the numerous noises we see in the marketplace on any given day. If I reacted to each of these I could not sustain a position for long enough for it to ake a difference to performance moreover my transactional costs would have me working for the market rather than the other way around.

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IPA
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April 24, 2017 at 12:25 AM ×

Bought gold futures @ 1273, will buy more if goes to 1263.

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