The Daily Prophet: Come Join the Cool Kids in Emerging Markets

Connecting the dots in global markets.

By all accounts, investors should be fleeing emerging-market assets. The Federal Reserve is due to start shrinking its $4.7 trillion balance sheet this month. In Spain, Catalonia’s separatists said nothing would stop their drive toward an independent state, raising fresh existential questions about the euro. In Japan, polls show falling support for Prime Minister Shinzo Abe just weeks before a general election he called.

Such a mix of risks would usually send investors fleeing volatile assets such as those found in emerging markets. Instead, the MSCI Emerging Markets Index has risen for four straight days, almost reversing a brief selloff at the end of September and bringing its gains for the year to almost 28 percent, compared with 16 percent for the MSCI All-Country World Index. Their bonds and currencies are also up for the year, resulting in a rare trifecta for investors. Morgan Stanley was out with a report Wednesday predicting more gains into year-end. What’s different now is that developing nation economies haven’t squandered the opportunity presented by a rare synchronized global economic recovery. Foreign-exchange reserves for the 12 largest EM economies, excluding China, have risen to $3.08 trillion from $2.89 trillion at the end of last year, providing a nice cushion in times of turmoil. 

Just this week, Brazil -- no stranger to political turmoil -- sold $3 billion of dollar-denominated global bonds due in January 2028 to yield 2.35 percentage points over U.S. Treasuries, down from the initial target of 2.50 percentage points in a sign of demand. In South Africa, the benchmark FTSE/JSE Africa All Share Index of equities closed Wednesday at a record high. The only major emerging-market currencies not to advance against the dollar this year were the Argentine peso, the Turkish lira and the Hong Kong dollar.

What goes up doesn’t always come down. Just consider the S&P 500, which has gained in 14 of the last 17 days, reaching new highs along the way. Although there’s no shortage of bears raising the alarm over what they see as abject complacency, the current run is actually quite common. Runs like this have occurred 13 times since 1990, with the last earlier this year, according to Bloomberg News’ Lu Wang. Since 1928, the 14-for-17 pattern happened 54 times, data compiled by Bloomberg show. Wang reports that while long stretches of gains can be viewed as a sign that stocks may have run too far, too fast, it’s also an indication of momentum that has been common to virtually all bull markets. The current streak comes amid a relatively benign economic outlook marked by low inflation and stable corporate earnings growth. Despite this year’s gains in stocks, price-to-earnings ratios have largely stayed the same at around 21 times. While that is high in historical terms, it’s not out of whack once the still low interest rates are factored in. 

The widely-followed Chicago Board Options Exchange SPX Volatility Index, better known as the VIX, gets a lot of criticism for not accurately reflecting volatility. The thinking is that the rise of trading strategies related to volatility, including exchange-traded funds, is keeping the so-called fear index artificially low. If you subscribe to such theories, then Bloomberg Intelligence ETF analyst Eric Balchunas has an alternative. In a research note, he says volume in the SPDR S&P 500 ETF Trust is emerging as an indicator of fear in the market as more investors and traders use the ETF in place of derivatives for liquidity and hedging. The ETF, the world's most traded equity, is experiencing its lowest volumes since 2007, falling below $1 trillion last quarter for the first time since 2007. Because the ETF is by far the most liquid vehicle, many investors and traders now use it as a portfolio tool instead of futures, which require rolling of contracts. The VIX now trades 24 hours a day, which Balchunas says has arguably diluted its movements, while the ETF’s volume comes during normal U.S. market hours. In general, unless the ETF's volume surpasses $40 billion in a day, any market panic likely will be short-lived. It last topped $40 billion following the U.K.’s Brexit vote in June 2016. On Aug. 24, 2015, the ETF traded $98 billion, the most ever by an equity, as the S&P 500 plunged.

The $3.8 trillion municipal bond market is perfect for widows and orphans, which is probably why small retail investors make up the bulk of the holders and not large institutions. Thanks to the taxing power of local municipalities, defaults are very low. The bonds are largely tax free, and prices rarely deviate by one or two cents on the dollar, according to Bloomberg News’ Brian Chappatta. Outside of a few high-profile failures -- think Puerto Rico, Detroit and Orange County, California -- the market chugs along year after year generating steady, albeit unimpressive returns.  But now, with a few seemingly off-the-cuff remarks, President Donald Trump has threatened to turn the whole world of municipal bonds upside down. Specifically, Trump said in a brief television interview that the bankrupt U.S. commonwealth of Puerto Rico might simply need to have its $74 billion of municipal debt wiped away. The assumption among investors was that the U.S. was advocating for a borrower to simply walk away from its debts. If Puerto Rico could do that, what’s to prevent another municipal borrower from doing the same when times get tough? Local borrowing costs across the country would rise in a direct hit to taxpayers. “It may possibly be the end of the municipal bond market as we know it,” Harry Fong, an analyst at MKM Partners, wrote in a research note. Puerto Rico is already addressing its $74 billion debt load through the bankruptcy process.

Maybe not so much in the U.S., but politics can still roil markets. Just look at Spain, where the benchmark IBEX 35 stock index slid 2.85 percent in its worst day since June 2016 as Catalonia’s separatists said nothing would stop their drive toward an independent state. Catalan President Carles Puigdemont has said he expects to declare independence within days following Sunday’s unofficial referendum, a vote that King Felipe VI and Prime Minister Mariano Rajoy have condemned. The yield on benchmark 10-year Spanish government notes rose to the highest in almost three months, or 1.78 percent. Spain has about $1.2 trillion in debt, which is a high 100 percent of gross domestic product. By comparison, Germany’s debt is about 66 percent of its GDP. Catalonia is important for Spain because the region accounts for a fifth of the nation’s economic output. The repercussions are already being felt, with drugmaker Oryzon Genomics SA becoming the first listed company to announce that it is moving out of Catalonia. What makes things extra complicated is that the European Union cannot mediate because it would give legitimacy to every region in Europe that wants to secede from the national state, according to Brown Brothers Harriman strategists.

For all the rhetoric from the Trump administration about reworking trade deals in favor of the U.S., the fact is that America’s trade deficit has only grown wider this year. Despite a weakening in the dollar that should theoretically make U.S. goods and services more competitive, the shortfall has averaged $45.6 billion through July, compared with $40.8 billion in the final yours of the Obama administration. To be sure, in an economy as big as the U.S. trade can’t be turned around overnight. It can take years.  The numbers for August, due Thursday, will attest to that. The median estimate of economists surveyed by Bloomberg is for the deficit to have been little changed at $42.7 billion from the $43.7 billion in July. The U.S. trade balance has been a wild card for U.S. economic growth of later, with five positive contributions and seven negative contributions to gross domestic product over the last 12 quarters, according to the economists at Bloomberg Intelligence. Net trade added a lowly 0.2 percentage point to GDP in each of the last two quarters, they found. 

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