Please note the views expressed in this bulletin are those of the author and do not necessarily reflect AMP Capital’s house view.

Theme 1: From emerging markets to ‘emergency’ markets

A significant washout is underway in emerging markets as structural challenges coupled with cyclical headwinds and financial stress weigh on emerging market assets. Ultimately, this washout will sow the seeds of a significant rebound, but it might pay to go with the flow in the immediate term. Often, such a washout in emerging markets only takes stabilisation in the fundamentals and a decisive easing of liquidity and financial conditions for the risk premium to be priced back out. Over the past few years we’ve seen that when the flows come back, they come fast.

Theme in pictures


Source: AMP Capital, Bloomberg, Thomson/Reuters Datastream

 

Theme 2: Beware of fragilities and risks in emerging markets

The prevailing narrative has changed on emerging markets. Last decade, it was all about the rise of the emerging market consumer, good demographics, China being set to surpass the US, the transformation of the BRIC economies (Brazil, Russia, India and China), catch-up potential, and a new paradigm. Now it seems the prevailing narrative is middle income traps, excessive leverage, poor governance, commodity crunch, and secular decline.

In the immediate term, US dollar sensitivity is being cited as the major negative for emerging markets (even though, ultimately, a weaker currency will improve competitiveness and profitability of trading). Indeed, a key part of the bullish thesis for European and Japanese equities has been the positive impact on earnings and economics from a weaker currency. In fact, some might argue that a weak currency is the key transmission mechanism of quantitative easing. Overall, it’s not clear that emerging market equities in local currency terms are doomed as a result of the drop in their currency.

Another consideration is the commodity link. There are a few notable commodity producers such as Brazil, Russia, and South Africa that have suffered in the wake of the commodity slump. But there are also major commodity consumer countries like China and India, which have driven a huge expansion in demand for commodities in the previous decade. This demand has faded in recent years at the same time as supply has surged. My inclination is to say the decoupling from commodities makes a bit of sense in the context of the enormous growth in supply, but it is something to keep an eye on.

Theme in pictures


Source: AMP Capital, Bloomberg, Thomson/Reuters Datastream

 

Theme 3: Link between a strong US dollar and Fed rate hikes is not clear

The consensus idea that the US dollar should undertake a massive bull market when the Fed hikes rates can be challenged. The main proposition around the strong US dollar includes: monetary policy divergence and economic divergence (i.e. Fed rate hikes vs easing elsewhere, and a strong US economy vs weak global economy). This thesis worked splendidly over the past 12 months, but in my view is close to running its course.

Firstly, the link between a strong US dollar and Fed rate hikes is not clear – it works sometimes and does not work other times. The historical pattern around the first rate hike in a tightening cycle is for strength in the US dollar in the months prior and a levelling off, if not softening thereafter. Secondly, the significant easing policies undertaken in Europe and Japan will work with a lag, so they should start to see improvement soon. This could mean the market begins to think about when that easy policy might be toned back. As such, US dollar strength is not necessarily a done deal. To my contrarian mind, it’s less of a done deal when everyone expects it and is taking a long position in US dollars.

Theme in pictures


Source: AMP Capital, Bloomberg, Thomson/Reuters Datastream

 

Theme 4: Falling inflation expectations will make it harder for the Fed to hike rates

Usually the Fed hikes rates when inflation expectations are rising, but recently inflation expectations have been falling. A couple of key factors are weighing on inflation expectations; the commodity collapse and the lacklustre global growth environment. We usually talk about the Fed running monetary policy for the US economy, and this is fair and accurate, but the US economy is not completely insulated from the global growth and commodities picture, certainly the inflation side of things. Indeed, the strong dollar, weak commodity prices, and weakness in emerging markets have weighed on corporate earnings in the US. Against a challenging global picture, the Fed may need to be more confident about the domestic situation before it begins raising rates.

Theme in pictures

Source: AMP Capital, Bloomberg, Thomson/Reuters Datastream

 

Theme 5:. Implications of implied correlations

Somewhat of a more obscure indicator, the CBOE implied correlation index is a ‘market-based estimate of the average correlation of the stocks that comprise the S&P 500 Index (SPX).’ This is a timely thing to look at because the breadth of the S&P500 has shown significant divergence in earnings results with some sectors performing better than others. In this situation, we should expect to see a fall in correlations between stocks; this is reflected in the CBOE implied correlation index.

The index may be mildly effective as a contrarian sentiment indicator for the S&P500 that helps to determine when there is too much optimism or fear in the market. Typically, it rises when the market sells off and climaxes at a market bottom. It also shows promise at giving contrarian sell signals when implied correlations drop. If you transform it by combining standardised level and smoothed rate of change, it gives a more accentuated signal, which seems to have some use as a contrarian buy indicator (when it rises), and a mixed record as a sell indicator (when it falls). In terms of market implications, it’s hard to make a definitive conclusion as the indicator has only been around for a few years.

Theme in pictures


Source: AMP Capital, Bloomberg, Thomson/Reuters Datastream

 
About the Author

Callum Thomas, MMgt (finance), MMgt (banking), BBS (finance), Investment Strategist

Callum is an Investment Strategist in the strategy team of the Multi Asset Group at AMP Capital. Callum has a passion for global macro investment strategy and constantly strives to generate unique and innovative insights that help inform the strategy team's dynamic asset allocation process. Callum is responsible for researching a range of asset classes and global macroeconomic themes to aid in formulating investment strategies across the Multi-Asset Group. He also keenly collaborates with the global equity and fixed income teams. Callum originally joined AMP Capital in June 2009 as an analyst in the investment business of what was then AXA New Zealand. He previously worked in strategy at the New Zealand Stock Exchange.

Contact us

If you would like to know more about how AMP Capital can help you, please visit ampcapital.com. Important note: While every care has been taken in the preparation of this document, AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) makes no representation or warranty as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. Past performance is not a reliable indicator of future performance. This document has been prepared for the purpose of providing general information, without taking account of any particular investor’s objectives, financial situation or needs. An investor should, before making any investment decisions, consider the appropriateness of the information in this document, and seek professional advice, having regard to the investor’s objectives, financial situation and needs. This document is solely for the use of the party to whom it is provided and must not be provided to any other person or entity without the express written consent of AMP Capital. © Copyright 2014 AMP Capital Investors Limited. All rights reserved.