Rally driven by Fed and China should be treated with caution
Shift in sentiment towards emerging markets most striking
What a difference two months can make.
As recently as February 11, global stock markets had just entered bear market territory – a fall of 20 per cent or more from a recent high – amid a surge in risk aversion stemming from a loss of confidence in the policies of the world’s leading central banks, in particular the imposition of negative interest rates in Japan and the euro zone.
Fast forward eight weeks and the panic that engulfed markets at the start of this year seems like a distant memory.
Having fallen 10.5 per cent in the first six weeks of this year, America’s benchmark S&P 500 index has since erased all its losses. Even global equities have recovered and are down just 1 per cent since the beginning of this year despite sharp declines in Japan and, to a lesser extent, Europe.
Yet it has been the shift in sentiment towards emerging markets (EMs) that has been the most striking. Having plunged 13 per cent in the first three weeks of January, the MSCI EM index, a leading gauge of the performance of EM shares, has since surged more than 20 per cent.
Many EM currencies, moreover, have bounced back dramatically. While the South African rand and the Brazilian real fell a further 17 per cent and 10 per cent respectively against the US dollar between early December and January 21, the two currencies have since rallied 12.5 per cent and 15 per cent respectively. Emerging Asian currencies, meanwhile, are on a roll, with the Malaysian ringgit and the Indonesian rupiah up 11.5 per cent and 6 per cent respectively against the US dollar during this period.
Indeed the research teams of some investment banks, notably ING, now expect emerging Asian currencies to appreciate against the US dollar for the whole of 2016, contrary to the market consensus which is for further declines.
What explains this newfound bullishness among a growing number of EM analysts?
Part of the rationale behind a more durable improvement in sentiment towards EMs is a significant easing of concerns about China – the initial trigger for the sell-off earlier this year.
ING believes the yuan will be more or less stable for the rest of this year, in stark contrast to the fears about a sharper devaluation which were prevalent in the second-half of last year and still persist. “There are strong economic and political reasons for the People’s Bank of China to stay the course in the fixing [against the dollar],” ING notes.
Another reason why many investors have become more bullish on EMs is the significant depreciation of the US dollar – the dollar index, a gauge of the currency’s performance against a basket of its peers, has fallen 5.6 per cent since the end of January – stemming from the more dovish stance of the US Federal Reserve.
The big question is whether investors are right to be less concerned about China and the Fed.
On Tuesday, the International Monetary Fund (IMF) delivered conflicting messages. On the one hand, it upgraded its forecast for Chinese economic growth this year – the only upward revision among the major economies – to 6.5 per cent from 6.3 per cent due to a raft of stimulus measures. On the other hand, it has become more bearish about China’s growth in the coming years due to persistent and growing imbalances in the economy.
More worryingly, the IMF notes that concerns about China’s economy and policy regime now have a much stronger bearing on investor sentiment. “China’s spillovers to global financial markets will likely increase considerably in the next few years,” it notes in its latest Global Financial Stability Report.
As for the Fed, the US central bank has acquired a reputation for surprising investors over the past year or so. Given the recent weakness of the US dollar and the persistent uncertainty surrounding the Fed’s guidance – particularly the extent to which the Fed is more market-dependent than data-dependent – it is entirely conceivable that bond markets may be underestimating the scope for further interest rate increases this year.
Perhaps most importantly, the recent rally in EMs is occurring amid a significant increase in volatility in markets, with the time between rallies and sell-offs having shrunk from nine months to a year between 2012 and 2014 to just three to six months today, according to insightful research from UBS.
This suggests that the next sell-off could occur as early as the middle of May.
Investors should treat the current rally with caution.
Nicholas Spiro is a partner at Lauressa Advisory