Top Advisors Corner

Fingraphs: USD Deleveraging in Emerging Markets, a Significant Risk in 2015

Jean-Francois Owczarczak

Jean-Francois Owczarczak


 

Early November, we reaffirmed our medium and long term positive view on the Dollar (“Still bullish on the Dollar, yet …” in the TAC 7th November).  Back then, we did flag that the short term rally could come to some exhaustion and indeed it materialised in the form of a lateral consolidation throughout most of November.  As we write, the Dollar is consolidating again following the new highs it made last week.  We still believe however that it has further to run in 2015.


On this FinGraphs’ Investor’s View (a combination of a Weekly, a Daily and an Hourly chart) although the Hourly (right hand chart) is currently correcting and may have further downside potential over the next few weeks (possibly back down to circa 87), the Weekly and Daily charts (left and middle) are still in respective Uptrends with more price potential (green projections) over the next few quarters and months.

As you may expect, many observers have recently focused on this rising Dollar perspective.  An angle that has been especially highlighted is the significant risks it may pose to some emerging market economies, their currencies and their stock market performances (the BIS, the Bank for International Settlement recently warned about it in their 4th Quarter December report).  Indeed, over the last few years, with investors looking for higher returns, much of the excess Quantitative Easing liquidity has found its way to emerging market.  This resulted in a booming of off-shore Dollar denominated debt (mostly to corporations) which to some accounts may now be as high $9 trillion.  Yes, borrowing at low interest rates in US Dollars seemed to be a no-brainer and many were calling the end of the greenback and its eternal depreciation (the so called USD carry trade).  Now that QE has ended, that rates are expected to rise and that USD has broken out into a new uptrend, the flow of funds should move in reverse with dire consequences for some emerging markets economies and potentially world growth in general.

There are several other factors that may worsen / trigger this USD squeeze, namely the drop in commodity prices for commodity exporting economies (especially oil), a competitive devaluation in Asia due to Japan’s own QE, a slowdown in demand from China affecting other emerging market economies, or more generally extreme levels of USD denominated debt owed by corporation or governments.  For all these, currency exchange rates are the main drivers as they define the cost and burden of holding and reimbursing USD denominated debt as well as the attractiveness of investments held in local currency.  It’s a dynamic process, the more USD appreciates, the higher the cost and burden of USD denominated debt and the more unattractive do local currency investments become.

Over the next few Mosaic Views will try to identify this deleveraging effect, assess if it is already underway and try to differentiate its potential impact on the different emerging economies.  We will use longer term Weekly charts (perspective over the next few quarters) and will consider the performance of each equity market in Dollars terms (top line) as well as the countries exchange rate vs the USD (bottom line).  This will help us capture the changes in attractiveness for each stock market in USD terms as well as more generally assess if the negative currency feed-back loop is underway.

Commodity exporting economies: 

Brazil (EWZ), Russia (RTS), Mexico (MXY) and Malaysia (EWM)

The recent drop in oil prices has meant that these countries are first to suffer.  Many oil projects are financed in USD and for these economies oil exports often represent a sizeable share of GDP.

Obviously, Russia is worst hit with USD skyrocketing against the Rubble and investors fleeing geopolitical risk.  The other three markets are however also suffering with renewed weakness in their equity markets and exchange rates vs the USD since the summer (rising exchange rate charts = USD appreciation).  As it happens, Brazil and Malaysia are also some of the more exposed emerging market countries in terms of international bank claims (many in USD) as a percentage of GDP.  This may also rapidly worsen their situation.  Viewing the charts we see that EWZ and RTS have been down-trending for several years, yet they are still negative.  MXY is holding on to a Bull trend which we now consider neutral as they are no more target projections and EWM is now negative and has a long way to go.

When considering the Investor’s View of the Reuters CRB Future Price Index below (heavily weighted towards oil), the downtrend still has some way to go and further USD strength will only accentuate the move.

The Weekly (left hand chart) is negative with more sizeable downside potential remaining over the next few quarters, the Daily (middle chart) and Hourly (right hand chart) are closer to exhaustion, but still negative for now.

China and Asian Emerging markets:

FXI and indexes redominated in USD for Thailand, Philippines and Indonesia

We have included China here (FXI) as it was the main focus of our contribution to TAC last week.  Although its GDP growth is decelerating more rapidly than expected, we are still quite positive on it.  Despite the recent rate cut, we do not believe China has any intention of widely devaluating.  This would be very counterproductive to its efforts to rebalance its economy.  Its corporations owe a significant portion of the world’s US denominated debt, but relative to its GDP (now the world’s biggest), it is still manageable.  FXI is still rising with more potential and our Risk Index is still quite low.  However, a Chinese “cold” may be much more damaging to its neighbours and other emerging countries.  Chinese imports are a major source of demand for them.  If you combine that with the current Japanese QE devaluation, probabilities are good that 2015 will see competitive devaluation is Asia (ex China).  The Philippines, Thailand and Indonesia (as Brazil and Malaysia) are quite exposed to US denominated debt in relation to GDP.  Their stock markets in USD terms are still trending up but have failed to make new highs (in Indonesia, targets are even labelled as only a correction up “C Up” in grey colour).  Since mid year, USD has started to accelerate again following a huge move in 2013.  USD denominated debts must be starting to bite, although for now all stock markets still remain in a potential uptrend.

Non-Asian developing markets:

e.g. South Africa (EZA), USD denominated indexes for Turkey, Poland and Hungary

These four countries are widely energy importers (although South Africa exports many other commodities).  They are however substantially exposed to USD denominated debt.  From what we understand, mostly private debt in South Africa and Turkey and at the government level in Poland and Hungary.

Although their stock markets show a mixed bag, their respective currencies have all been depreciating against the Dollar (PLN and HUF are pretty much pegged to EUR).  South Africa (EZA) is still in an uptrend, but has seen a lot of volatility in recent months (and a linear drop in recent weeks: not shown).  Istanbul and Hungary have deceived over the last few years both in USD and local currency terms.  Poland has started to correct.  Although falling oil prices may help these countries in the short run, their debasing currency vs the USD may also mitigate that effect.

The effects of USD deleveraging on emerging equity markets is most clearly seen on oil exporting countries for now (and may be mostly due to the oil price drop itself).  However, none of the other markets have reached post financial crisis new highs and some are already negative.  $9 trillion of off-shore USD denominated debt is a large amount.  Considering that all currency charts are still widely in favour of USD over the next few quarters, the pressure can only rise and once the deleveraging process starts, it is self-fulfilling.

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Have a great weekend,
J-F Owczarczak (@fingraphs)