If there is one thing that markets have become accustomed to in recent years, it’s their risk-on risk-off nature, primarily centred around the outlook for US interest rates, and as an extension the US dollar.
Where sentiment towards the future actions of the Fed goes, so too do risk assets.
A dovish Fed is good, while a hawkish Fed is bad, more or less. Yes, there is the odd exception to the rule, but it really is as simple as that. This week has been no exception.
A woefully weak US non-farm payrolls report for May reignited the risk-on portion of the trade, weakening the US dollar and fuelling gains in risk assets.
Weak data is good, strong data is bad — that’s how investors have been programmed to react to in the years following the global financial crisis, and that’s exactly how they’ve reacted this week.
A near-term US rate hike it off the table, so it’s time to move into riskier assets. It’s the US dollar versus everything else, continuing the well-worn pattern.
The recent gain in emerging markets (EM) hasn’t gone unnoticed by Caesar Maasry, Jane Wei and Olivia Kim, analysts at Goldman Sachs.
However, while others believe that the poor US jobs report provided a green light to resume buying in riskier assets, the trio believe that it was not a fundamental positive for EM.
“The main narrative of EM’s recent trajectory tends to focus on the Fed, where the futures market showed an increasing probability of a June hike during May and a recent unwind of these probabilities,” they say.
“The disappointing US jobs report last week may keep pressure on the Fed not to hike in the very near term, which in turn may keep USD appreciation on hold and the long-end of US rates at bay.
“(However) the decline in rates in recent days, due to a poor jobs report, does not bode positively for broad risk sentiment, and as we highlighted before, increasing developed market (DM) risks bode poorly for EM.”
While Maasry, Wei and Kim suggest pressure has been taken off emerging markets by diminished US rate hike expectations, they believe this is unlikely to underpin risk assets as it did earlier this year.
“Unlike the rally of the past few days, the initial stages of the EM rally in January and February coincided with strong data points from the US,” they note.
The chart below, supplied by Goldman Sachs, shows the sharp improvement in US economic data at the start of the year, which coincided with lower US interest rates, something that contributed to the sharp rebound in EM.
The difference on this occasion, they suggest, is that emerging market valuations were significantly cheaper compared to now. They also note the rally in EM that eventuated earlier this year was partially fuelled by a decline in US interest rates, something that has already occurred on this occasion.
“Although rates may not climb higher in the near term, we do not see potential for rates to fall much either,” they say.
While they don’t expect emerging markets to rally much further as a consequence, the trio don’t believe there’s a risk of a savage selloff, at least not yet.
Instead, they expect a “muddle through” period for EM over the next few months, suggesting that such a scenario will favour credit markets over stocks.
“Looking more broadly across EM assets, last week we wrote that a ‘muddle through’ climate tends to favour credit over other asset classes, with equity underperforming,” they say.
“We envisage such a scenario panning out over the next 3 months; and at the margin, the latest NFP print furthers this argument as a potential signal of weaker economic growth and a pushed out Fed hiking trajectory.”
In terms of risks to their call, they suggest that a “hawkish shock from the Fed would likely weigh more heavily on EM credit markets than
“We would take this risk in the near term and find that the relative trade tends to underperform if US rates rise 30 bp or more over the course of three months.”
So there you have it. Long EM corporate credit over the next three months — unless the Fed turns hawkish.