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EM divergence on the increase

Fall-out from Argentina, combined with global growth concerns, results in increased divergence between EM sub-sectors.

Global equity markets were once again volatile with a sell-off to start the week before staging a comeback. The net result was a loss of approximately 1% on the week and down between 3-6% on the month, depending on the market.

The US yield curve also inverted for the first time since 2007, evidencing investor concerns over the global slowdown, which is weighing on risk assets.

There was, however, some good news as President Trump struck a more conciliatory tone on the trade front by delaying tariffs on USD170bn of Chinese goods, while the Chinese also signalled that they will visit Washington as scheduled in September for face-to-face meetings.

Huawei was granted a reprieve as Wilbur Ross said the Trump administration would extend a temporary license to allow companies to sell products for repairs or updates to the Chinese company for a further 90 days.

In emerging markets (EM), the big market news was the fallout from the shock Argentine PASO results the prior weekend. The market was clearly unprepared for this and the subsequent VAR shock to investors’ portfolios sent high-yield credit materially weaker.

A combination of the Argentina news and global growth concerns also led to a USD bid and currency weakness, while local rates markets held up much better.

Market review

  • Argentine assets continued to reel from the prior weekend’s PASO results, where the Frente de Todos party (led by the Fernandez-Fernandez ticket) took an almost 15% lead and achieved 49% of the positive vote, making a first-round victory in the actual election in October the most likely path.
  • Over the weekend, Argentina was downgraded to CCC by Fitch and to B- by S&P, which, when combined with a weekend interview by Alberto Fernandez with less-than-assuring comments over the debt stock, led to more selling of Argentine assets. This was followed by the resignation of the Economy Minister Nicolas Dujovne, who was replaced by Hernan Lacunza, who was the minister of finance for the Province of Buenos Aires and has previous experience at the central bank. He has been tasked with the difficult role of stabilising the financial markets (most importantly the ARS) as we approach the October elections and through until the likely government transition in December.
  • In China, the PBC announced that banks are to price new loans using loan prime rates rather than over the benchmark rates set by the People’s Bank of China (PBC). The idea is to lower banks’ lending rates and to allow these to become more sensitive to market rates (which are much lower than the PBC benchmark rate).
  • On the data front, Chinese July activity data disappointed with retail sales missing expectations and infrastructure spending unexpectedly slowing.
  • In Mexico, Banxico cut its policy rate by 25bps, citing a deterioration in the economy and indicating that further cuts are likely.

Market outlook

The rally in duration over the past month, along with last week’s inversion of the US Treasury curve, evidences the market’s concern over the future path of growth.

Europe remains the global laggard but there have also been recent disappointments in the Chinese data, while the US continues to outperform.

Politics is also playing an increasingly important role in the market psyche, in our view, with concerns ranging from the collapse of the Italian coalition to Brexit to the Hong Kong protests (to name a few).

It is therefore hardly surprising that investors are increasingly questioning the longevity of the global expansion. To add to this, trade policy in the US remains very difficult to read for investors and companies alike and is logically curtailing capital expenditure plans for corporates, weighing on the outlook.

We see accommodative central banks continuing to be the counterbalance to the above narrative. To that end, investors will likely focus on any clues from the Jackson Hole symposium starting on 22 August. With the US economy outperforming, it seems difficult for Powell to out-dove market expectations.

The G7 meeting this weekend in Biarritz will also be closely followed for any clues around trade and fiscal stimulus. There has certainly been more chatter around fiscal easing in Europe lately and with the rally in duration, this could have important implication for rates, in our view.

Overall for EM, we have witnessed the concerns highlighted above play out in a large divergence between high-yield credit (underperforming) and investment-grade credit (outperforming) in hard currency markets, and in FX (underperforming) and rates (outperforming) in local markets.

The huge move in Argentine assets has sent a VAR shock through the market and exacerbated this divergence. We would expect some of this to mean revert over the coming weeks if Argentine assets can stabilise around current levels.