Watch the Emerging Markets

Strong US economic data in recent weeks have caused analysts and economists to boost their expectations for US corporate earnings and the economy at large. The data have also led the Fed to reaffirm its commitment to removing policy accommodation at a gradual pace. On its face, it certainly seems as though the Fed is justified in continuing its present course. The unemployment rate has dropped below what many economists believe to be the Non-Accelerating Inflation Rate of Unemployment, or the NAIRU. At the same time, inflation is now at or above the Fed’s target of 2% as measured by a variety of different metrics. At this stage, then, it seems that better wage growth is the last remaining item on the Fed’s “wish list.” But while wage growth is certainly lower than we’d expect given a 4% unemployment rate, wages too are growing well above the Fed’s 2% inflation target. So what’s to keep the Fed from continuing its present course or even accelerating its policy normalization? Why is there any debate at all over the issue?

Aside from the risk of asset bubbles (which we believe significant and directly attributable to Fed monetary policy), the most threatening factor that could influence the Fed’s calculus is the action in the emerging markets (EM). A combination of trade-war threats, Fed interest-rate hikes, and softer EM economic growth has caused significant market volatility outside the US. EM currencies, stocks and bonds have plummeted in recent months, and this volatility could have very real implications for the rest of the world. Perhaps the most immediate threat is that EM entities have issued a massive amount of dollar-denominated debt in recent years. These issuers could have a much more difficult time servicing and refinancing that debt if capital continues to flee the EMs. And as we all have learned from the Financial Crisis, problems in one sector of the debt markets can easily spill over into sectors – a process known as contagion.

In the charts below, we show that in just a few months this year, an 8% decrease in the MSCI EM Currency Index has corresponded to 20% sell-offs in both EM equities and EM bonds.

 

Losses sustained in the EMs can also have more direct effects on US economic growth.  As capital flows into the US from abroad, the dollar will continue to appreciate.  A sharply higher dollar can affect US economic growth through our trade balance and can affect corporate earnings by making US companies less competitive. The Commerce Department’s recent data show the trade deficit for July at over $50b and accelerating at the highest pace in three years; US exports are declining as retaliatory agricultural tariffs are showing an impact and the strong dollar makes US goods more expensive. Meanwhile, imports continue at a record pace. A rising dollar also creates deflationary pressures in the US as cheap imported goods are substituted for domestically produced goods, further impacting the trade balance.  And while it appears as though the Fed has finally succeeded in boosting inflation to its 2% target, there is no reason why those gains couldn’t be fleeting against the backdrop of slowing global growth and a surging dollar.
Right now, the odds of the Fed raising interest rates twice more this year (for a total of four) stand at over 60%.  However, if the current trends in the EMs and currency markets continue, we would expect the Fed might signal its willingness to pause its interest-rate increases until EM volatility subsides.  The immediate after-effects would likely be lower capital outflows from EM; stabilization in EM currencies relative to the dollar; a steepening in the US yield curve as inflation expectations rise and growth expectations improve; and, yes, a “risk-on” environment including higher stock prices.  Stocks have been beholden to Fed monetary policy for so long that we don’t see why anything has changed now.  With a new injection of its lifeblood under this scenario, we could see another leg higher for the US stock market.  But it wouldn’t come without the risks of asset bubbles and an eventual surge in inflation.  And the Fed also must take into consideration the complicating issues of trade negotiations and President Trump’s (real or perceived) threats to the Fed’s independence.

We live in an increasing interconnected world.  As such, the extent to which the US economy can “decouple” from the rest of the world is much more limited than it once was.  You may hear the opposite from the pundits on TV, but the reality is that the currency and capital markets are forces that work to smooth growth rates across the world.  We think there is a good chance that economists and the Fed will start to heed their warnings in the coming months.