A couple of weeks ago in “‘This Was Inevitable At Some Point“, we asked a simple question: is there a storm coming for emerging markets?

The point was pretty simple really. EM has held up remarkably well in the face of what is supposed to be a Fed tightening cycle. Indeed, Q1 worked out quite well if you were long anything with the prefix “EM.”

(Goldman)

In a testament to just how “cray” EM’s resiliency truly is, we also noted (a short while after the post linked above was published) that on a Fed Minutes day, the Vanguard FTSE EM ETF got its biggest daily inflows since 2012 ($872.5M):

(BBG)

Here’s how we attempted to explain the apparent anomaly:

Attribute this resiliency as you see fit. That is, maybe it was the fact that the dollar had a terrible Q1. Or maybe it was partially due to the fact that the March Fed “hike” was actually a “cut” if you care to consult financial conditions. Or maybe no one is buying what the Fed is selling in terms of their intentions. Or maybe today’s portfolio managers are too young to remember what a tightening cycle actually is.

Well on Wednesday, Goldman is out asking an important follow-up question. Namely, “if the VIX sneezes, will EM catch a cold?” Excerpts from the note are below.

Via Goldman

The 10% rise in the S&P index since the US election was catalysed by a surge in optimism surrounding US policy. While the hoped-for policy changes now appear less likely, ‘soft’ data have shown continued strength, leaving the S&P index hovering just under 2400 as investors wonder whether economic activity can catch up to sentiment and support another leg higher in asset prices. While opinions on that question remain split, what is clearer is that, as investors continue to wait for the global economy to ‘show me the activity’, they have become increasingly nervous about the prospect of a large, sharp S&P drawdown: the VIX index, which had remained around 12 through much of 2017Q1, now stands close to 15 (Exhibit 1).

 

How concerned should EM investors be if the S&P were to see a large reversal of its post-election gains? On the one hand, the ongoing improvement in macro fundamentals has contributed to a surprising resilience of EM assets to a wide range of external shocks in recent months, including fluctuations in US policy perceptions, DM rates and commodity prices. More specifically, Exhibit 2 shows that, in 2017, both EM equity indices and EM currencies have been far less sensitive than usual to shifts in the S&P index.

 

Exhibit 3 makes clear, however, that EM assets have not faced a true test in 2017: a large S&P drawdown and a spike in volatility and investor concern (the upper-left tip of the S&P’s ‘volatility smile’). Indeed, it has been more than a year since the S&P has seen a 10% drawdown, and volatility (both realised and implied) remained near historical lows for much of 2017Q1. Each of these trends was supported by rising momentum in survey-based measures of activity that – even if ‘hard’ data were to pick up – would be difficult to match in the remainder of 2017. If the market is forced to wait much longer for a follow-through in activity data, and the VIX continues to rise, EM investors should not be complacent: despite improving macro fundamentals, an S&P drawdown when the VIX index has reached high levels would likely be painful, especially given that investors have continued to build EM positioning. Exhibit 4 shows that the sensitivity of EM assets to the S&P index is, unsurprisingly, far higher when the VIX is elevated.