Macquarie: EMs still in the gun

Via the excellent Viktor Schvets at Macquarie:

EMs in the crosshairs: Between war games, fake news and bonds

From military exercises to trade wars, the fury is intensifying. At the same time, global liquidity is compressing while rates are rising. Growing uncertainty, contracting liquidity & rising cost of capital will continue to place non-US assets (and in particular EMs) in the crosshairs.

“Wag the Dog” showed the power of ‘fake news’ but…

In the 1997 movie ‘Wag the Dog’, a spin doctor was hired to help distract people from sex scandals by staging a televised ‘fake war’ in the lead-up to the Presidential elections. It was the first time that Hollywood described what has recently become known as meddling or convincing people that ‘white is black’. These days there are far more efficient and potent ways of targeting voters & disseminating fake news than Brean (spin doctor) could ever have imagined.

Ever since then the life has been imitating art. From John Kerry’s swift-boat controversies in ’04 to data dumps and fake accounts in ’16, the avalanche of bots and news (fake or otherwise) has become so overwhelming that people have no chance to process it, and separate the wheat from the chaff. As societies no longer agree on what truth is, there is no need for verifiable facts.

…it could all go badly wrong while liquidity continues to tighten

This brings us to the latest news that the US Seventh fleet might conduct military exercises in the South China Sea. Although there are real issues at stake (freedom of navigation), there is clearly considerable room for accidents and unexpected turns. The same applies to use of blunt instruments like tariffs & sanctions. After all the fury, the new NAFTA is not that much different to the old (albeit more protectionary) and the same applies to the new KORUS, while oil prices are now as much reflection of sanctions as fundamentals. Investors seem to be relieved when the fury merely subsides rather than because new agreements are better. It is like starting a war, and then declaring a victory.

However, as in the movie, there is always a possibility that the plot might just go terribly wrong. Whether, it was calling a ‘slam dunk’ referendum on Brexit, or agreeing on limits on Italian deficits (even as no one believes its veracity) or a possibility of accidents at high seas, politics is reflecting public confusion, and cries for help. It leads investors into dark corners of  deglobalization and Balkanization, rising identity politics and inability to find compromises. We view ‘trade wars’ not as occasional occurrences but rather as a ‘trench warfare’ that would last for decades. The same applies to geopolitical & social tensions.

As if this is not enough, markets are also likely to be impacted by declining global liquidity (all of our indicators are falling). There can be no synchronised growth and asset price supports unless US & China see eye to eye (political, fiscal & monetary). Instead, we are getting a lopsided growth in one part of the globe (US) which threatens to suck the life out of the rest of the world. As  the Fed decided to put back ‘accommodative’ into discourse, we have seen a knee-jerk reaction in global rates, with US 10Y reaching ~3.2%. As long as the Fed views the world through local lenses, global liquidity would contract.

Ultimately, neither China, the Fed nor the US is in a ‘mutual suicide pact’; either there is a robust & global private sector recovery (unlikely), or the Fed, US & China would need to pull back. The question is how much non-US (and later US) pain would need to be endured? EMs remain in the cross-hairs; but also we should not underestimate impact on the high-yield markets.

China is already blinking with rising stimulus which will offer fundamental support to EMs even as the Fed increases the monetary sucking sound. I expect the US will add more stimulus post-mid terms and see another year of good growth in 2019.

It’s trade war boom time.

David Llewellyn-Smith
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