2016 turned out to have a tough start, 3 weeks of equity and commodity weakness triggered by China and oil seems to have run its course for now. The market is in a tentative recovery mode, helped by stabilizing oil and China liquidity injections before local holidays. It seems as things progress better US data will keep risk sentiment in check with the help of Europe and credit spreads will come back down from current levels. The process of course could take some time with the down drift in US real GDP growth. At the moment risk is tracking oil prices which have been pushing lower for some months now. The recent attempt to establish a base around 27 USD seems to have held for now but we will have to see how much of a bounce oil can really put in. Meanwhile, the structural risks that drove the sell-off have not really gone away, Chinese and falling US corporate profits are only behind the scenes.
On the positive side, Fed related risk is now much smaller than last year. After the recent market turmoil, FOMC is likely to adopt a cautious approach to its tightening cycle. At the same time likelihood of policy loosening and possibly new methods of asset purchases is now higher than last year. These two factors help limit deep falls in global equity prices for the time being even in a low profit growth context. Recent data suggest that US is going through a weak patch under the influence of a rapidly contracting mining sector. Annualized US real GDP fell from 3,9% to 2% in the process and growth should bounce back to 2% region soon enough as energy share in GDP keeps getting smaller. In China, which is a larger cause for concern, growth trends are actually less disconcerting. Chinese indicators suggest output growth is largely stable with the help of stimulus from the government and the central bank. That being said, overcapacity is still there and real estate still seems to pose risks.
On a global scale, these were the two main risk factors in the last few weeks. If we look at emerging markets, there are not many structurally positive stories to report at the moment. US hike cycle, weak commodities, weaker fundamentals and structural problems have been haunting emerging markets for over a year. All these problems aside, there is a price for everything and a discount rate for every problem. In fundamental terms most Emerging Market economies continue to struggle but they have become somewhat resilient to shocks as outflows decreased invested foreign capital and devaluation of currencies aggressively cheapened valuations. At this point, commodity prices do not seem to be set for a strong rebound with weak demand growth from China and Asia. In the absence of a major credit spread rally, the EM countries are unlikely to a much better ability to borrow from abroad this year. However, further ECB action in March could change the game for emerging markets. If credit spreads are tightened following further asset purchases by the ECB Emerging Markets could be huge gainers in an easy credit, low inflation, low growth environment. In a stable scenario such as the one I have laid out the Emerging Market sell-off that has been trending for almost 2 years could hit a large correction.
Recently, the risk selloff was not generally worse in Emerging Markets than G10. Emerging Market currencies lost value leading to some underperformance of unhedged local currency assets but dollar denominated assets such as eurobonds did not really get hit since the move was compensated by rallying US treasuries and the outcome was a spread widening rather than a decline in value. The spread over UST on the EMBI Diversified Emerging Markets index rose by 77 bps in the first 3 weeks of January before falling about 20 Bps in the last 3 trading days.
Conclusion: Emerging Market weakness trend seems to be nearing an end as effect of risk aversion on Emerging Market spreads stay subdued. Possibly the reduction of positions and devaluations of the last 2 years have brought Emerging Market valuations to a level where sellers are limited. This could mean in a low interest rate, low inflation environment such as now Emerging Markets could gain some lost ground back if the ECB delivers in March.
