Call it “Rodrik’s Trilemma” for the Emerging Markets: the combination of higher rates, rising oil prices, and a stronger dollar has historically been a “terrible trio” for EMs according to Goldman’s head of FX, Jeff Curries, who writes that as higher funding costs and capital flight to the US force domestic deleveraging, the pressure on EMs tends to be so great that these periods don’t last long: i.e. a short circuit event takes place, usually in the form of a market crash. And, as the subsequent damage lingers, the trio often ushers in weaker EM economic growth.
We bring this up because a “terrible trio” is precisely the environment under which emerging markets currently find themselves in, and as Currie points out, “these trio periods signal one of two events: 1) a mid-cycle pause or 2) an end-of-cycle turning point”, i.e. a global recession, usually accompanied by a market crash.
To be sure, conceding that a “terrible trio” environment has brought us to the end of the current cycle would not be prudent for Goldman which still remains resolutely bullish on the global economy and risk assets (just last month Goldman upgraded tech stocks, expecting years of upside for the FANGS).
So what does Goldman expect? Here is Currie with the baseline forecast:
We see several reasons why the current trio likely signifies the former. First, the rates curve is not inverted as it was during previous turning points (and negative term premia now make it somewhat questionable if inversion of the yield curve would even warrant as much concern as in the past). Second, commodities have far more slack (barring a large geopolitically driven supply disruption). And third, the real US dollar trade-weighted index is not nearly as strong as in past trio periods.
Of course, that is the best case outcome in which the “short circuit” emerges without toppling the house of cards.
However, there is also a downside case: should current trends persist, and if higher rates and rising oil and commodity prices are not accompanied by a weaker dollar, the current EM problems will likely intensify warns Currie.
Case in point: The trucker strike in Brazil this year—and the related hit to activity—occurred as oil prices denominated in Brazilian real reached the highest levels on record.
Which brings us to the next topic: The virtuous and vicious cycle of rates, oil, and the dollar.
Here the Goldman analyst argues that most of the 2000-2010 period was characterized by lower rates, rising commodity prices, and a weaker dollar. In other words, “this was a virtuous cycle.”
Rising oil prices weakened the dollar and generated excess savings that were repatriated into US debt markets. This resulted in lower US yields, which reduced funding costs to EMs. Lower funding costs in turn led to more demand for commodities and commodity price reflation. In all, this virtuous cycle led to the three “Rs”: Reflation, Releveraging and Re-convergence of central bank policy. This dynamic was also on display during late 2017 and early 2018.
However, the danger is that taken too far, this virtuous cycle can, and eventually will reverse into a vicious one of higher rates, declining commodity prices, and a strong dollar, shifting the three “Rs” into the three “Ds”: Deflation, Deleveraging, and Divergence in central bank policy.
This was the case in 2014-2016 when higher funding costs forced EM deleveraging, which reduced commodity demand and reinforced lower commodity prices. In turn, lower prices reduced excess savings and helped strengthen the dollar.
It took the Shanghai Accord of 2016 to halt the vicious cycle when China unleashed on what was at the time a historic standalone releveraging episode, one which promptly provided support for global markets and developed economies.
And now, a little over two years after the Shanghai Accord, it’s time for another short circuit as there is one notable constraint on the virtuous cycle: US oil demand. Currie explains:
Today, a virtuous cycle could not run as long as it did in the 2000s because in many EMs, savings now equals investment, so higher commodity prices create more real-world demand and less excess savings. Furthermore, the US no longer runs a
large current account deficit driven by oil. Another key difference is the US appetite for oil. Historically, Chinese demand was the main driver of commodity prices and thus played a major role in these reinforcing cycles. Even during the boom in US shale oil production in 2015, US supply was only a part of the story; Chinese demand for oil and commodities collapsed during that period. Today, US oil demand is growing like Chinese oil demand, consistent with a strong US economy. At the same time, supply disruptions in places like Venezuela, Libya, and now Iran have plagued the oil market, making the rise in oil prices that much less palatable.
So what is needed to reverse the vicious cycle and make into a virtuous again? Goldman believes that one of the three components: rates, dollar or oil, has to snap, or as Currie says, “something’s gotta give.“
The bottom line is that some part of the trio has to give for EMs to regain solid footing. We agree with our FX strategists that the most likely candidate is the dollar, especially as oil fundamentals remain tight even with the recent OPEC+ announcement of additional oil supplies.
For now however, with the Fed continuing to tighten, this does not appear like a realistic possibility. What about oil?
The Trump administration has tried to talk down oil prices, and also has some tools to push prices lower if these efforts to convince OPEC to further boost production fail. Ultimately, the president could tap the Strategic Petroleum Reserve (SPR), and there is a precedent for doing so to tame oil prices around elections.
And here a warning: “during a past trio period in October 2000, President Clinton turned to the SPR.” However, at least in that instance, Democrats still lost the election, and recession ensued.
As for the most recent period, the financial crisis, some have argued that it was oil’s surge to $150 that prompted the global economic collapse that unleashed a deflationary wave upon the world, concurrently with the financial crisis.
In other words, unless the concurrent surge in the dollar, in oil and higher US rates is somehow halted, there is only one possible, if unpleasant, outcome.
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