Equity bulls are betting that a dovish US Federal Reserve will pump air back into the deflated equity market bubble. That doesn’t exactly inspire my confidence; it says that the equity market is a bubble to begin with, dependent on ultra-loose monetary policy.

The composition of recent equity market gains, as I noted yesterday, is dodgy. Apart from General Electric, a dead cat that bounced, the top performers in today’s S&P 100 Index are Netflix (+6%), a movie studio disguised as a streaming content company selling at 95 times trailing earnings, and Nvidia (+6%), which today acquired Huawei as a competitor; the Chinese firm overnight unveiled a new big-data chip that competes head-to-head with flagship products of Nvidia and AMD.

But the fact that the Fed finds itself on its back foot is good news for some markets. The local currency debt of emerging markets was beaten up badly during 2018 when the dollar soared in response to Fed tightening, China allowed the RMB to soften as it eased monetary policy, and Brazil and Turkey blew up.

Emerging market bond ETF v currency index

That’s why emerging market bonds performed worse than emerging market stocks (which also got beaten up). When EM currencies devalue, the stock price of local companies that earn revenues in foreign currency adjusts upward – but not the price of local currency bonds.

The chart below shows the price of the emerging markets bond index vs the price of the emerging markets stock index (the ETF’s that track these indices are, respectively, EMB and EEM). The time period is September 2015 through today.

EM stocks v bonds

They trade in a straight line, or rather two straight lines. At the beginning of 2018, the line shifted to the right, which means that emerging market bond prices traded at a lower level relative to emerging market stock prices. That’s the result of the collapse of EM currencies at the start of 2018, shown in the first chart. I’m convinced that EM currencies have stabilized.

Brazil now has a free-market government advised by a University of Chicago economist, and the long period of uncertainty that crushed the Brazilian real is over.

Turkey saw its lira in free-fall during most of 2018, but the Turkish unit stabilized towards the end of the year as a political dispute between the US and Turkey was resolved. US-Turkish relations are on a solid footing now. Most important, the drop in oil prices is an enormous relief for Turkey’s negative current accounts balance.

China’s RMB hit a ceiling of 7 past which the People’s Bank of China will defend it. Southeast Asia looks particularly strong.

Last year, Chinese bonds were the outstanding performer, returning 7.7% in US dollar terms, that is, taking into account the depreciation of the RMB. With the 5-year Chinese bond yielding just 2.93%, most of the gains are behind us.

But other Asian nations still offer very high yields with low volatility – the Philippines, Indonesia and India in particular. Asian government bonds, as well as Asian credit, offer attractive yields and acceptably low volatility to dollar-based investors. Even taking into account the effect of lower emerging market equity and currency prices, emerging market bonds are far below value.

US stocks had modest gains after the National Association of Purchasing Managers released a report on services only slightly worse than the consensus forecast.

US manufacturing and services PMI

Last Thursday, a sharp drop in the manufacturing purchasing managers’ index provoked a 660-point drop in the Dow Jones Industrial Average, and contributed to Fed chair Jerome Powell’s conversion to monetary moderate the next day. Services showed a much smaller decline.

That isn’t surprising. We saw the same pattern in China last week, where the Caixin manufacturing PMI came in below expectations but the services PMI came in slightly better than expectations. The epicenter of trouble in the world economy comes from shrinking CapEx and world trade, which hits goods before services.