Periphery to the Core Dynamic: Weak EM Currencies equals Underperforming Stock Markets

I’ve written about how weak Asian currencies are most likely to be transmitted into asset markets. 

The theoretical underpinnings have been that if the developments in the real economy should get reflected on asset prices then a weak currency would imply increased domestic inflation pressures (requires more local currency to buy foreign goods that compounds on domestic financial repression policies), and more importantly, higher debt servicing costs on foreign currency loans  (requires more local currency to service dollar based loans).

There are of course exceptions to the above such as when governments monetizes fiscal expenditures by massively inflating, stock markets become safe haven from currency destruction or runaway inflation  (Venezuela and Argentina as examples) or when government purposely fuels a stock market boom by buying financial assets from the private sector (current examples BoJ and ECB)

Since the latter two political conditions haven’t been pervasive in emerging markets, the likely result from strong dollar (weak EM currencies) has been highly fragile risk assets.

The Gavekal team presents technical evidence of such underperformance in their post “Rising US dollar=Narrowing Market Performance” which measures market internals during the recent risk ON episode.

Trends like the advance/decline ratio have a strong correlation with the USD as can be seen in the charts below where we compare the 100 day moving average of the A/D ratio to the nominal effective, trade weighted USD.

Applying to Emerging Markets here is what Gavekal observed:

In the emerging markets, the trends are comparatively worse.  Here only 29% of companies have outperformed the MSCI World index over the last 50 days, while only 23% have outperformed over the last 20 days.  The trends are getting worse for the EMs.

Percent of Companies Outperforming the MSCI World Index by Country

on a per sector basis…

Percent of Companies Outperforming the MSCI World Index by Sector in Emerging World

The Gavekal concludes:

Over the last month:
1) The USD has continued to rise.
2) There has been NO change in leadership off the bounce.
3) The market has narrowed more.

All these signs suggest that investors should continue to focus on North American counter-cyclical companies.  There is no rotation yet, and as long as the USD continues to rise, we should expect a continued narrowing of market performance.

Narrowing of performance means distribution or that global stock market breadth has been weakening despite the present risk ON landscape. 

Yet if the “narrowing” dynamic is sustained will this translate to an eventual drag to the current leaders? I expect so.

And if EM hasn’t been picking up in the face of a central bank induced risk ON landscape, how will they perform when risk OFF returns?

As for the Philippines, there has been an astonishing rise in the frequency and intensity to  “massage” the equity benchmark. This has been channeled through intraday buying panics on select heavyweight issues, the regularity of “marking the close”  and the most current innovation—pushing select heavyweight issues to get past record highs in order to generate the "greater fool" momentum and to improve sentiment. 

Yet the data above (relative performance vis-à-vis MSCI world) seems to reinforce signs of the massaging of heavyweights through poor breadth (plus deteriorating volume) and how such actions have so far failed to meet its objectives.