There are tentative signs that this week’s risk sell off, particularly in emerging markets, could be taking a breather. The Argentinian equity index rose more than 4% on Wednesday, and the Brazilian index is up some 0.5%. The Istanbul index is also up more than 1% on Thursday, which is symbolic since Turkey was the first, and the worst, hit of the emerging markets during this most recent rout. The improvement in sentiment towards the EM sphere is slowly starting to thaw European indices, which are starting to find their feet and claw back recent losses. Even EMFX is catching a break today, and the South African rand is taking the top spot in the EM FX space and is up nearly 0.3% vs. the USD.
We mentioned on Wednesday that the indiscriminate selling of emerging market assets would likely come to an end, and we think that the EM rout could be overdone for a few reasons:
- the decline in EM FX was, in part, down to the rise of the dollar. However, the dollar index still doesn’t look ripe to break above the mid-August 12-month high at 97.00, and 100.00 still seems like a pipedream, especially with US-based event risk coming up, including September’s Fed meeting and the US mid-term elections in November.
- the decline in EM equity indices was largely a result of the decline in EM FX, and was not triggered by a weakening in EM corporate fundamentals (although some regions are suffering more than others). Rather, FX is a large component of EM equity returns for foreign investors, so when the currency falls, the equity index tends to be sold. The reverse is also true, so if EM FX stages a recovery then equities should follow suit.
- the fundamentals didn’t add up: we would firstly like to add a caveat that some EM assets are at risk from political and economic pressures (read Turkey), however justifying the ZAR sell off when SA’s current account deficit is lower than the UK’s right now isn’t a good investment decision. Also, political risk is not just the preserve of the emerging market space, take a read of today’s New York Times’ anonymous op-ed from a Trump cabinet member and you will see how close the US is to a constitutional crisis.
Overall, a relief rally is in sight on Thursday after a few consecutive days of heavy selling. Whether or not this is a breather, or the end of the attack on risk, we shall have to see. We recommend that you watch the Swiss franc and the yen, we would expect them to decline if risk sentiment is to recover.
Can a political risk premium topple tech?
The other thing we will watch today is tech stocks. After yesterday’s Senate hearings for Facebook, Twitter and no-show Google, the tech sector took a beating, with Twitter down more than 6%. If the US Congress is to investigate the tech giants for competition concerns regarding free speech and the free exchange of ideas then this says that the tech titans are fair game for lengthy investigations and potentially huge fines, if they are found to be abusing their positions. Tech has already been under scrutiny by the EU, Google was slapped with a $5bn fine earlier this year, and if the US takes the same stance then we could see a political risk premium added to tech, which could erode its position as the sector driving US equity dominance. This could spell a headache for US equity bulls as they try to find other sectors that are large enough to make up for a potential pull-back in tech.
Going forward, we are not willing to call the top of the market quite yet, but we may be fairly close and we would expect defensive sectors and companies with strong balance sheets to start to out-perform. Ironically, this could include Facebook, whose balance sheet is in good shape and in the second half of 2018, the social network could be the best-positioned tech giant to whether a political storm. The chart below shows sectoral performance of the S&P 500 in the last 12 months. Tech is turning lower, after outperforming since February, financials are also looking shaky. However when in doubt about the prospects for US equities, investors put their faith in the US consumer. Record low unemployment and a slight pick-up in wages is driving consumer discretionary, and consumer stocks could be the bright spot for US indices as we lead up to the end of the year.
Source: Bloomberg and Capital Index