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Quarterly Liquidity Insights - Q3/2020

The MSCI emerging markets index rose solidly again in Q3 although the gain was narrowly focused on a few large markets. The global backdrop continues to improve while domestic money growth is strong in most EM countries. We remain hopeful that the performance pick-up will be sustained into 2021, with a combination of global “excess” money, strong economic growth and an associated rise in commodity prices driving a catch-up of some of this year’s laggard markets.

The Q3 index return was slightly ahead of the MSCI World developed markets index and reflected further gains for the “covidsafe” markets of China, Korea and Taiwan together with a rebound in India – these four markets account for three-quarters of index market cap. 11 of the 26 MSCI markets delivered a negative return, however, with a further eight underperforming the index by more than 3 percentage points.

Covid containment performance only partly explains year-to-date country return differentials. India and Brazil have had similarly awful experiences but the Indian market has proved resilient while Brazilian stocks have plunged. The worst performers have been commodity producers, capital importers and markets where overaggressive monetary policy easing has undermined the currency. Relative covid trends are shifting favourably for EM, with a recent fall in E7 new cases driven by Brazil and India contrasting with a rise in the G7 – see first chart.

Chart 1: COVID New Cases (7D MA, 000s)

The performance of EM equities as an asset class is strongly influenced by global economic momentum and liquidity. Global money growth has surged to its highest level since the 1970s, suggesting a potential economic boom in 2021 if virus disruption can be contained – second chart. Money growth has probably peaked and could fall sharply over coming months but an associated moderation of economic growth is unlikely to unfold until H2 2021, allowing for the normal nine-month lead. Ongoing policy stimulus, moreover, will probably maintain the level of money growth above its 2010s average.

Chart 2: G7+E7 Industrial Output & Real Money (% 6M)

A further reason for optimism about near-term economic prospects is an apparent undershooting and bottoming out of the global 3-5 year stockbuilding or inventory cycle in Q2 2020 – third chart. The upswing in this cycle is likely to extend into early 2022 and has historically been associated with upward pressure on commodity prices and outperformance of EM equities. The biggest commodity price increases occurred in the early 1970s and after the GFC following similar surges in global money growth.

Chart 3: G7 Stockbuilding & Industrial Commodity Prices

The rebound in global markets since Q1 reflects, in our view, the opening up of a record gap between global real money and output growth, with “excess” liquidity, as usual, flowing into financial assets. The six-month growth gap is likely to close in Q4 as base effects cause a temporary surge in output momentum but an excess may be restored in early 2021. The initial beneficiaries of surplus liquidity were bond markets and quality growth equities but a rotation into cyclical sectors and EM has begun and could gather pace into 2021 in the global acceleration scenario described above.

A stable or weakening US dollar has historically been necessary for excess global liquidity to flow into EM assets. The Fed’s broad trade-weighted index has returned to around its 2019 average after a Q1 spike and there are grounds for expecting further weakness, including the Fed’s commitment to an inflation overshoot and a record US trade deficit. A rise in E7 10-year government bond yields (GDP-weighted average) relative to a G7 composite could attract capital inflows and boost currencies – fourth chart.

Chart 4: 10Y Government Bond Yields (GDP Weighted)

There are risks, however. The relative strength of US money trends suggests greater potential for upside growth and inflation surprises, which could temper the Fed’s dovishness. A Biden / Democrat sweep in the elections, similarly, could result in a bigger fiscal boost, reducing pressure on the Fed to remain ultra-loose. Market positioning indicators suggest that investors are short the US dollar versus other majors, though not against EM currencies.

We have stronger conviction in our view that the global economy will surprise positively than in a sustained decline in the US dollar and associated pick-up in capital flows to EM. This suggests overweighting “cyclical” markets with a tendency to outperform during global economic strength at the expense of “liquidity-sensitive” markets potentially at risk from a back-up in US Treasury yields driving a dollar rebound. This perspective also informs our preference for cyclical equity market sectors.

The generalised rise in money growth across most EM countries has meant fewer signals for country allocation from relative money trends. The strongest numbers, moreover, have often been in countries where monetary policy easing has been overaggressive, leading to currency weakness. With policies stabilising, money trends are likely to cool and may show greater cross-country divergence, with implications for relative economic and market prospects.

“Cyclical” markets where high money growth suggests the potential for positive economic surprises include Brazil, Russia and Korea – fifth chart. “Liquidity-sensitive” markets that might underperform in the event of a rise in bond yields include Mexico and South Africa.

Chart 5: Real Narrow Money (% 6M)

Chinese money growth continues to lag the EM average, reflecting conventional / measured monetary policy easing, which has recently started to be reversed. Other factors have dominated so far in 2020 but the monetary backdrop may act as a drag on relative market performance going forward.

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