This morning, on his way to the G7 meeting of major economic powers, President Trump made it clear that he has, for now at least, no intention of backing down from a trade war with America’s allies. He laid into trading partners such as Canada and the European Union, citing unfair practices on their part. One could argue about the desirability of that policy and its potential effects on the U.S. economy, but it is fair to assume that the stock market is generally pro-free trade, so will not react kindly to this hardening of attitude, at least in the short term.
So far though, the long-term assumption seems to have been that the tough talk is a negotiating ploy, and that when all is said and done we will return to close to where we were, only with the U.S. in a slightly more advantageous position than before. That, based on what we know about Trump’s style, seems to be a reasonable assumption, but until the whole thing plays out, the most likely outlook for U.S. stocks is continued volatility but with essentially sideways movement.
That seems to be the conventional wisdom, but when I agree with conventional wisdom my dealing room background makes me look around for somewhere that I don’t. In this case, that is found in what all this means for emerging markets.
As you can see from the chart above for the iShares Emerging Market ETF (EEM), the market’s outlook there is far more pessimistic. Since the extreme volatility at the beginning of the year, EEM has settled into an extremely bearish pattern of lower highs and lower lows. From a technical perspective, that suggests that we will break below the support at around $45 and head lower. When the fundamental reasons behind the drop are analyzed, however, it seems that the bearishness on emerging markets is not really justified.
The conventional wisdom case is laid out in this post at cnbc.com, where Chad Morganlander from Washington Crossing Advisors is quoted as saying that EEM has further to fall for three reasons. The first is the technical analysis, with which I agree, but technical analysis can only take you so far, and is always trumped by fundamentals. Where I differ is in terms of the two fundamental arguments made. Morganlander says that China’s attempts to cut back credit growth and a rise in the dollar will both add to the downward pressure on emerging markets.
With regard to the first, you must consider the two possible outcomes to the current trade disputes and how that will affect China’s policy in the future. If the trade war between America and its major trading partners continues and intensifies, continued tightening in China would be a suicidal policy and would quickly be reversed. Admittedly in that worst-case scenario global trade and therefore growth would suffer, but in that case, there will be nowhere for investors to hide.
What is far more likely is that the conventional wisdom case on trade overall will play out, with a period of tough talk fading once a few concessions have been made. If that is what happens, some degree of tightening in China would actually be a positive in terms of its dampening effect on inflation fears. Either way that looks like an exaggerated fear.
The argument regarding a strengthening dollar is even less convincing. A glance at the above chart for the dollar index shows that after hitting the long-term resistance level at 95, the index has been gradually dropping for a couple of weeks. There are two reasons for that, and both suggest that further declines are coming.
The first is that Fed rate hikes will inevitably force the dollar higher. That is logical, but it ignores the fact that the forex market, more than any other, tends to price in expectations early and is therefore prone to a buy the rumor, sell the fact pattern. If, at their meeting next week, the Fed announces a 25-basis point hike and the desire to continue with gradual “normalization” it will be exactly as expected.
It may cause a very short-lived pop in the dollar, but profit taking will follow quickly. This week, the ECB said for the first time that they would consider tightening themselves and when that becomes the dominant narrative in the forex market, further dollar declines will come.
Emerging market stocks are always more volatile than those of developed countries and as a result, news and expectations, both positive and negative, tend to get overplayed. That seems to be the case here, where all the possible negatives of the current situation are priced into EEM, while the U.S. market is taking a much more optimistic view. They can’t both be right.
Opposing a strong narrative is always risky, but with the strong support for EEM at around $45 close enough to allow for a cheap stop-loss just below it that limits potential losses, it looks like a risk worth taking this time.