A reversal of trend in the US dollar has intensified the effects of US monetary tightening on emerging markets, causing a sharp sell-off in EM bonds. Further, it has exacerbated weakness in those emerging markets seen as most vulnerable to funding pressure and deterioration in risk appetite.
The obvious question now is whether the correction will turn into a bear market?
This is a risk because the US equity market is driving this correction and I believe the US market has peaked for this cycle.
If the US market plunges, the close link between the US market and emerging markets shown below suggests that Asian markets will be pulled into a bear market.
However, this still not a likely outcome in my view. Here’s why: With the sole the exception of 1987, the US market has never plunged unless economic growth was also weakening sharply. There is little indication at present that US growth will slow meaningfully, let alone sharply, until 2H18F. Earnings revisions remain positive suggesting the US market is more likely to experience a slow rounded peak, as occurred ahead of the three previous bear markets. If this assessment proves accurate, I expect US market downside will be moderate and followed by a US market rebound into early 3Q18F. A US market recovery, even a half-hearted one, would provide room for Asian markets to rally, with some Asian markets attaining new highs.
That said, even with a stable US market, Asian markets could enter a bear market if the recent strength in the US dollar turns out to be the beginning of a sustained trend. The next chart shows that Asian forward EPS growth has peaked and subsequently decelerated below US forward EPS growth in US dollar terms. The growth advantage favoring EM will quickly dissipate if US dollar strength persists for too long.
Recent US dollar strength reflects the sharp widening of yield differentials in favor of the US dollar since Mar, extreme speculative positioning against the US dollar and capital repatriation associated with US tax cuts. While capital repatriation may well continue, strength due to positioning support from yield differentials has nearly peaked.
Thus far I have been surprised by the shallowness of the correction in most markets. The correction remains smaller in proportionate terms than the correction of 4Q16 in the HSI and many Asian markets. A normal correction should take an index below its 200-day moving average and should invoke fear. I would expect the Hang Seng, for example, to correct at least 38.2% of the 2017 rally — consistent with a correction low of 28,900.
So, bottom line, I think there is more room for play in the Asian markets before I will begin to worry about it being a bear market. I am looking to buy.
If an Asian bear market has begun, I expect to see three signals: (1) The US dollar Index breaking above the Oct high of 95.15, (2) the Hang Seng breaking below the Dec low of 28,134 (and the MSCI EM breaking 1,100), and (3) Asian markets appearing to have already bottomed – India and Singapore, for instance – breaking below their Mar and Apr lows, respectively.