MorningWord 5/25/16: Spooz Key Action at a Distance – $SPX, $EEM

by Dan May 25, 2016 10:05 am • Commentary

Yesterday, Zerohedge made an interesting observation (via Bank Of America Merrill Lynch) of the decoupling taking place between emerging market stocks and the S&P 500 (SPX). That was also the case prior to the two sharp draw-downs in the SPX in August and January:


It may also be worth noting emerging market debt, as measured by the EMB, (the iShares Emerging Markets Bond etf that tracks JP Morgan’s EM Bond Index), was recently rejected at the 52 week highs, with a sharp drop after the April Fed Minutes:

From Bloomberg
From Bloomberg

The EMB might be worth keeping an eye on as EM debt was clearly at the eye of the storm last year as the U.S. Dollar traded near highs vs almost every EM currency as expectations of Fed Rate hikes rose.  A look dating back to pre-financial crisis levels shows the extreme stress of that period and the subsequent snap-back and base above $100 for years. Since the all time highs in 2013 though, the etf has been in an obvious downtrend, with the Jan lows marking massive long term support:

From Bloomberg
From Bloomberg

Last year’s (August) surprise devaluation of the Yuan by the PBOC was the match that ignited the massive brush fire in global risk assets. And last night, the PBOC fixed their currency at the lowest level since March 2011. Does the latest action mean that the PBOC fears a June rate hike from the Fed? One that would have the dollar higher and capital flight out of China, once again causing them to act?  The issue as it relates to dollar strength and EM currency weakness is the amount of dollar denominated debt, and the cost to service it as the dollar moves higher.

And we all know what lies beneath all of these fears as China is sitting on a debt bomb. If there’s an impending crisis coming, it could be sparked by a series of Fed rate increases, thus weakening global economic conditions. From Bloomberg:


So it’s all a big vicious cycle, as the U.S. attempts to normalize monetary policy after years of debt deleveraging, while emerging markets like China attempt to manage slower growth and avoid a hard-landing for their economy. And by manage, I mean debt fueled monetary and fiscal policy, which for all intents and purposes is merely kicking the can down the road.

The de-coupling of U.S. stocks from EM stocks is unlikely to remain if the USD remains bid, and dollar denominated EM debt continues to grow, while real economic growth continues to slow.  Any re-coupling would lead to the sort of downward volatility shock we saw in the SPX in Aug/Sept & Jan/Feb.