Friday, August 16, 2013

Emerging Markets: The Global Macro and Sentiment Trade

The case for investing in emerging markets (EEMs) right now is this: funds are at a record underweight and macro expectations are beating to the upside by the largest amount in the past two years. That is a potent combination: in addition to growing local consumption, EEMs are export-driven, especially of commodities, that would come back into fashion with improved G10 macro growth.

Moreover, EEM equity markets are highly sensitive to foreign fund flows: rebalancing in the past has led to outperformance. But, and this is key, that works both ways: when developed markets fall, EEMs do as well and more often than not, they fall harder. That, in short, is the risk/reward for EEMs.

Correlated sympathy plays on the same dynamics are steel (SLX) and copper (JJC).

EEMs are the most out of favor equity region among fund managers right now (green line). A net 19% are underweight at the moment, the lowest in 12 years. The last time EEMs were this out of favor was late 2008 and EEMs outperformed SPX through the concurrent trough. In comparison, in February, EEMs were the most favored equity market (43% overweight) and they subsequently have been the worst performing equity region of 2013.

In comparison to all asset classes and on a relative basis, EEM equities are the single most out of favor and under-owned asset.

Right now, macro expectations are beating by the largest margin in 2 years (blue line). This has a triple effect on EEM. First, money flows into equities and out of bonds (yellow line, first chart below). UST yields, which rise/fall with growth/contraction, also correlate fairly well with EEMs (second chart below; TNX is UST 10 year yields)).

Second, global growth implies demand for things EEMs produce (like commodities), increasing local income and therefore domestic consumption as well. Copper (first chart below) is a sympathy play with EEM, both produced and consumed in EEMs. Steel is also a sympathy play (second chart below). Coincidentally, global funds are 23% underweight commodities.

Third, and finally, when macro expectations are outperforming, risk-seeking increases and EEMs often outperform developed markets (green shading and middle panel). The rub, however, is that the flows work in reverse just as well, and money tends to run home when developed markets fall. That is no small risk at present (read further here and here). The silver lining at present is that EEMs are at a record underweight, a situation similar to late 2008, and EEMs held up better (yellow shading).

In the chart above, EEMs have hardly started to outperform (middle panel). If there is a new cycle starting, it is early. EEM had the first buy signal (MACD cross) last month. Above $40 (key resistance) is the next buy signal, from which there is potential to move another 10%.