The Daily Prophet: Emerging Markets Turn Into Latest Pain Trade

Connecting the dots in global markets.

Emerging-market equities are suddenly in a nasty slump. The MSCI EM Index fell 1.52 percent Wednesday, bringing losses to 4.84 percent since peaking on Nov. 22. While stocks everywhere have hit a rough patch of late, the decline in EM equities is notable considering that the MSCI All-Country World Index is little changed over the past two weeks.

There's an old saying on Wall Street that markets will tend to do whatever causes the most pain. And the selloff in EM comes as almost everyone seems to be piling in. The Institute for International Finance said last week that net capital flows to EM were on track to exceed $115 billion in 2017, a marked improvement from outflows of $550 billion in 2016 and $620 billion in 2015. There's two likely reasons why EM stocks have been under pressure. First, technology stocks have been in a downward mode, and the MSCI EM Index is tech-heavy, with a 29 percent weighting, topping the S&P 500's 25 percent. Second, the commodities market is back on the decline, and many EM economies are based on raw materials. Since Nov. 6, the Bloomberg Commodities Index has dropped 4.59 percent.

Whether the recent slump is just a pause that refreshes or marks a turning point remains to be seen. But what the bulls should take comfort in is the sense that the global economy seems to be gathering steam. And although leverage continues to rise across EM, the strategists at Bloomberg Intelligence say EM's external resilience is improving, inflationary pressures are in decline and growth expectations are accelerating.

Then again, the slide in commodities is picking up momentum. The Bloomberg Commodities Index fell on Wednesday to its lowest level since early October. It has fallen 2.74 percent this week in its steepest three-day decline since March. So, what's behind the slump? Much of it has to do with a decline in base metals such as copper and lower energy prices. Copper just suffered its biggest one-day drop in two years and the mood in the market is souring, according to Bloomberg News' Mark Burton. Even though prices are still up dramatically this year, there are four main reasons traders are cautious: Copper inventories held in global exchanges remain stubbornly high; the forward price curve also signals that loose supply conditions may persist in the coming months; concerns are mounting that China’s crackdown on its property market will be a headwind; and there are concerns about how and when a large long position that accumulated in Shanghai Futures Exchange contracts in recent months will be unwound. In the energy markets, oil prices have dropped by about $2 a barrel the last two weeks amid speculation an extension of production cuts by OPEC will do little to curb supply. That's because U.S. shale explorers have been a thorn in the side of the OPEC-led coalition, boosting output on an almost-weekly basis all year, according to Bloomberg News' Jessica Summers.

America's currency is increasingly looking like it's poised for a sustained move higher. The Bloomberg Dollar Spot Index rose for the third straight day Wednesday, and for the seventh time in the past eight days. Yes, the total gain over that period is an unimpressive 0.83 percent, but for long-suffering dollar bulls there is reason to be optimistic. More Wall Street firms are expressing confidence in outlook for three -- or even four -- interest-rate hikes by the Federal Reserve next year as the economy gathers strength. Then there's the knock-on effect from the U.S. tax overhaul. David Woo, the bank’s head of global rates, FX and EM fixed-income strategy and economics, figures the greenback could rally as U.S. companies repatriate cash parked overseas to take advantage of lower tax rates. He predicts the greenback will strengthen to $1.10 per euro next year from about $1.18 now, and to 122 yen from about 112.30 yen at present, with gains concentrated in the first half of the year, according to Bloomberg News' Lananh Nguyen. Of the $4 trillion in corporate cash that President Donald Trump says is held offshore, Woo estimates 70 percent is in dollars. That leaves 30 percent, or $1.2 trillion, in other currencies, and if companies convert a quarter of that within three months of a tax overhaul, that would be a major boost for the currency. “Immediately after tax reform gets passed, you’re going to hear this giant sucking sound,” he said. “This money’s going to be heading home very quickly, and that’s going to be very bullish for the dollar.”

Bitcoin, the cryptocurrency that Wall Street can't stop talking about or stop watching, hit another new record high on Wednesday. This time, it surged more than 10 percent to breach $13,000 for the first time, marking a more than 15-fold increase this year. The surge “should be tamed with adult supervision in 2018,” as futures trading in bitcoin on regulated exchanges gets under way, said Mike McGlone, a Bloomberg Intelligence strategist. “There is little doubt that bitcoin and cryptos are stealing some gold demand interest, at least in this parabolic stage,” McGlone said. “When the crypto rally reaches its apex, gold should regain more shine. That looks like a good prospect in 2018.” So, how bad could the bitcoin selloff get? McGlone took a stab at that question by looking at bitcoin's trading history and figures it should find support near $6,000. McGlone also notes that bitcoin recently moved more than 75 percent above its 60-day moving average, putting it into what he calls "a very high-risk zone." "Since 2014, moves of 60 (percent) above the 60-day mean have marked good resistance levels," McGlone wrote in a research note. "The June 6 mark at $2,871 -- 87 (percent) above the 60-day mean -- was the most extreme since 2013. More than a month later, the low-retracement mark was $2,159, about a 25 (percent) decline."

There was a lot of concern at the start of the week about municipal bonds as investors braced for a deluge of new debt as issuers raced to borrow before Congress enacts legislation that would cut the size of the tax-exempt bond market after this year. But rather than cave in to what some estimated would be $19 billion to $21 billion of new issuance, or almost triple the average this year, the market has held up quite well. In fact, the securities haven't rallied this much since 2011, according to Bloomberg News' William Selway and Brian Chappatta. On Wednesday, those yields dropped 0.08 percentage point to 1.96 percent, according to data compiled by Bloomberg. It seems that the prospect that the new sales of tax-exempt debt could fall by a third or more starting next year has made existing securities more valuable to investors. "There’s a fear that there’s going to be a scarcity of municipal bonds going forward," Gary Pollack, a managing director who handles fixed-income research and trading for Deutsche Bank’s private wealth division, told Bloomberg News. "I’m buying as many bonds as I can." Pollack said he recently bought bonds in offerings by New York, a Sacramento utility and the Virginia Public Building Authority.

There's a simple reason why U.S. consumer confidence has been rising through the roof: Americans feel more wealthy. It's not just an illusion. The Fed said in September that the net worth for households and non-profit groups rose by $1.7 trillion in the second quarter to a record $96.2 trillion, driven by solid gains in financial assets and rising property values. On Thursday, the Fed will probably say the momentum continued in the third quarter, with Bloomberg Intelligence forecasting an increase of $1.8 trillion. BI says rising home values and equity prices have had a positive impact on consumers, lifting household wealth and benefiting existing homeowners and supporting personal spending in the absence of more robust growth in personal income.

If you’d like to get The Daily Prophet in e-mail form, right in your inbox, please subscribe to this link. Thanks!

Europe's Yield Curve May Hold Key to Markets in 2018: Ben Emons

Nafta Renewal Would Benefit U.S. Investors: Komal Sri-Kumar

The 2018 Outlook for Major Central Banks: Mohamed A. El-Erian

The ECB Is Right to Get Tough on Bad Loans: Ferdinando Giugliano

Matt Levine's Money Stuff: Regulatory Armies and Bitcoin 12,000

    Before it's here, it's on the Bloomberg Terminal.