Some further thoughts on traditional “EM”

Photo by Eugenia Clara on Unsplash

We often refer to the market as an aggregation of diverse views, knowledge and opinions, and as a base case we tend not to believe that we are individually smarter or more perceptive than that aggregated intelligence. In a way, along the lines of the conversations we are having on the side about AI and distributed computing, “the market” – the collection of stock, fixed income, crypto and everything else in between markets all around the world – is arguably the most distributed high performance computing machine in the world.

It has eyes in every little nook and cranny around the world, ingesting data and news 24/7 (there’s always some machine or human somewhere out there thinking about something at any given time) and forming opinions that are expressed as trades, conviction as size and ultimately translating into moves in price and volume which are both outcomes and inputs into someone else’s process.

So the best way to test out a theory is to look and see if it seems to be playing out somewhere in the world: not so much in the heart of trading activity where all sorts of different motivations cross paths, but more on the fringes, where the number of variables that are in focus, and which matter, is much smaller, allowing the effects of whatever driver we are interested in to be observed more cleanly.

For a while now, we’ve been increasingly of the view that there is an incoming regime change, namely a structural weakening of the US dollar. We are not aiming to over-intellectualise and get sucked into the de-dollarisation story going on everywhere we look but rather just put together the pieces as they seem to be falling.   Most certainly, we are as always open to the prospect that we may either be wrong, or that this being a structural view means in that in the interim, there may well be liquidity induced rallies that are violent and big. We are in a very unusual and difficult economic regime and there is always that risk, and those are risks that we need to manage even as we hold a bigger picture view.

But if we were to look for structural signs of this happening, away from the liquidity-driven centres of attention, where better to look for the manifestations of a weaker USD than in our old hunting grounds, the so-called “Emerging markets”? After all, as the (largely valid) conventional belief in the EM world goes, weak USD = strong EM, especially in the banks and some consumer names, particularly those that have USD-denominated input costs like manufacturers of staples and food products.

So off we went, looking at charts, to see if we could find evidence that either proved or disproved our thesis.

Caveat: recessions and the USD

The one caveat we needed to consider this time that would nullify some of the “traditional” playbook is in commodities. Traditionally, when faced with a weakening USD, the first reaction would be to look for “real” assets that retain their real value vs a declining USD. For certain EM markets, that’s an added kicker: the miners of South Africa, Brazil and Indonesia, for example, would typically enjoy the benefit of being big commodity producers – at least that was the experience of the last time we saw a “supercycle” more than a decade ago, albeit with commodity demand getting the extra support from China.

Furthermore, the synchronicity of USD strength/weakness with the broader economic cycle seems to be inverted this time: whereas typically we’d be looking at weak USD being a consequence of a Fed reaction to a weak economy, looking to stimulate it with lower rates, and hence an expectation of growth being around the corner, this time we’re starting to see weakening USD happening at a time when the US is still strong, with a recession being expected around the corner, the severity of it yet to be determined.

The net effect is that the growth expectations, at least from the US standpoint, that are typically anticipated by a weak USD environment that underpin the traditional playbook especially with commodities, aren’t in play this time.

Add to uncertainty about the sustainability of the Chinese reopening trade on global growth and it’s quite clear that following the old “weak USD = buy commodities” chapter of the playbook is unlikely to work very well. At least not yet.

Fortunately, at least for now, the rest of the orthodoxy seems intact.

It’s Charting Time

We’ll start with the ones that we were already tracking: Indonesia, for example, is ground zero for where we’d expect to see this outperformance play out. Macro fundamentals are strong, as a result of years of well-made policy, bringing improving balance to the country’s external accounts. Internally, the consumer is strong, as we’d already noted more than a year ago. No surprise then that when we pull up a chart of BBCA denominated in USD, we get a classic bottom left to top right bull market chart that interestingly has been going on for years:

Likewise in the consumer space, an old favourite, PT Kalbe Farma (KLBF) – sensitive to FX especially given its imported raw materials for nutritional products (including milk, biscuits, snack bars etc), this segment being its largest earnings contributor – shows exactly what “sensitivity” looks like on a chart:

Moving slightly northwards from Indonesia to the Philippines, it seems like a similar thing is happening. For example, here’s the chart of BDO Unibank, again in USD:

And just for comparison, here’s the same chart in PHP:

On the consumer products side of things, the story appears very similar in the Philippines as it is with Indonesia: strong consumption volume growth despite price increases demonstrating the pricing power of some of the domestic consumer staple champions.

For example, Century Pacific, which produces and sells canned food in the Philippines (lack of liquidity being the major issue for this stock):

This isn’t even a southeast asia only phenomenon: India, which is another economy that is very sensitive to FX, directly and indirectly, seems to be behaving in the same way.

HDFC Bank, for example, is trading at all-time highs – not unlike BBCA:

And in the consumer staples space, this chart is quite hard to ignore – our only gripe being that we didn’t spot this earlier:

The examples could continue but the point here is that we are seeing substantial evidence across markets outside the “core” of Europe and the US that this trade is playing out as we speak. But most importantly it is across a far narrower subset than the label of EM would historically suggest. This makes sense as we have written ad nauseum that the label, EM, is an anachronism.

Dispersion’s back

The markets of the past few years have been extremely US and macro-centric, as the climax of the great US bubble came to pass: whether in meme stocks, tech stocks, MAGMA (fka FAANG), S&P500 trackers etc, leaving almost every other market in the world looking on in despair, wishing for even some scraps of attention. Sure, China had its fair share of drama and attention, Russia drew in probably the wrong kind of attention, and all around the world we had short episodes of action in the likes of Brazil and Turkey (the latter coming back into the spotlight soon with impending elections), but in general it’s safe to say that no one really had any reason to bother too much because all the action was in the US.

We theorised that this would change, and increasingly it does look like it is happening – not in a linear way, as always, but certainly in the right direction.

Most importantly, what that means is that once more our approach needs to evolve: it is probable that the tea leaves of FOMC minutes and dot plots continue to matter, but equally probable that they matter much less than before, in favour of a different set of tea leaves in a different cup (or tea room).

Perhaps it’s time to pay more attention to the “fringes” again, as “Emerging markets” stage their re-emergence – not with the same drivers as before, but to the same effect.

Whichever way you want to slice this, the simplistic and succinct observation is that a weak dollar is in general a good thing for good ol’ EM. But our view is that real EM is a far smaller subset than it used to be.