Oil and USD Rallies Shake EM…

The oil rally reflects the fundamental tightening we were writing about since late Q2. Crude futures moving into backwardation last summer saw oil tanker storage turn uneconomic and the popular ‘glut’ narrative which saw several high profile bank analysts predict $40-45/bl Brent this year is now shifting…keeping 1.2 mb/d (plus nearly 0.6 m bpd from non-OPEC) offline for another year could push the market into a deficit situation, leading to accelerated inventory drawdowns and prices heading to the $80-90/bl range in H1 19. That’s a scenario worth stress testing in portfolios…’  4th January 2018 blog post

The macro outlook described back in December was for an asset allocation environment of rising rates, oil and the USD – the dollar rally took a long time to arrive, but JPM’s emerging market currency index has tumbled to its lowest level since early 2017. We’re seeing an unusual divergence between the declining broad EM USD carry index versus rising broad commodity indices, with which it usually correlates positively – that will have blown up a few hedge fund macro books.

That anomaly is partly because energy has dominated the commodity rally YTD and diverged from industrial metals impacted by slower Chinese credit/fixed investment (indeed short metals versus energy was one of our December resource trades) and US shale capturing some of the windfall from higher oil prices. We downgraded our view on EM equities to neutral coming into 2018, having been overweight since Q1 16. Arguing for the ‘cheapness’ of EM equities by looking at price to book or PER discounts to DM is simplistic; on an EV/Sales versus operating margin basis, the picture is far more nuanced across the EM universe with Asia looking most compelling, albeit distorted by IT where H2 earnings are now being broadly downgraded. Indeed, Asian tech was one of the most crowded bets cross global portfolios in Q4 an hasn’t delivered, while overall MSCI EM earnings momentum on a three-month rolling aggregated net analyst revision basis is now negative, as indeed is European.

Our view was that a growing divergence between Chinese growth and US inflation (and rates) momentum would become a key portfolio factor as dollar liquidity peaked and ebbed.  On that basis, the consensus long EM and euro trades looked vulnerable to sudden reversal, and indeed popular  carry trades have become lossmakers over the past month as the first signs of an offshore dollar funding squeeze emerge. For the euro, 2-year yield and relative macro data  differentials versus the US suddenly matter again and positioning remains very vulnerable to a further selloff, even if Italy’s new populist coalition avoids further antagonising Germany with ECB write-off talk.

We’ve been long DXY as well as global oil equities in our tactical portfolio, although the crude rally is now extended, with Brent at our year-end target and discounting immediate geopolitical risks. We noted bearish cognitive bias as a factor back in the January post, but the growing number of $100 forecasts from the same IB analysts calling for $40 a year ago reflects the career incentive to herd and momentum chase.

If Q1 was a dollar inflection point and DXY is headed for 100 plus alongside crude in the $70-80 range and 10-year yields sustaining a move above 3%, EM will be a net loser as QE morphs into QT through H2 at a time when import bills surge for twin deficit countries like India and Indonesia after recent FX weakness. The pressure to curtail current account deficits/domestic demand will intensify as funding tightens while more aggressive FX intervention running down official reserves  and pressure to hike rates (as in Indonesia this week)  will become widespread policy responses over the next few months – it’s hard to see even Turkey resisting for long more.

The rise in offshore leverage across EM since 2009 has been broad, although focused in some markets in the banking system (e.g. Turkey where the loan to deposit ratio has reached 120%) and in others the non-financial corporate. There is certainly no immediate prospect of a rerun of the 1982 Mexican or 1997 Asian crisis but the IB “buy the dip, this time is different” mantra looks as misplaced as their blind panic on the asset class in early 2016 deflation scare. When it comes to analyst groupthink, this time is never different…