Enjoy the rally in emerging markets while it lasts
Sentiment depends on oil prices not collapsing, growth in China holding up and the Fed maintaining a measured pace of rate increases
For an indication of how investor sentiment towards emerging markets (EMs) has fared since the victory of Donald Trump in the US presidential election on November 8, look no further than the Mexican peso.
In the eight weeks following Trump’s triumph, the peso – dubbed the “Trumpometer” during the election campaign because of Mexico’s acute vulnerability to the protectionist measures pledged by Trump, which included withdrawing the US from the North American Free Trade Agreement (NAFTA) and building a wall along the US-Mexico border to keep immigrants out – plunged nearly 20 per cent against the dollar.
Yet since mid-January, it has been a different picture altogether.
A flurry of conciliatory comments from members of the Trump administration, coupled with a successful currency hedging programme by Mexico’s central bank, have contributed to a dramatic 15 per cent rise in the peso versus the greenback since January 19.
Indeed, since the beginning of this year, the peso, which lost more than 20 per cent against the dollar in 2016, has been the world’s second-best performing currency.
The best-performing one has been the South African rand - another vulnerable EM currency because of a toxic combination of domestic political risk and the South African economy’s heightened sensitivity to downward pressure on commodity prices – which has shot up more than 10 per cent against the dollar.
The sharp improvement in sentiment is not limited to the peso and the rand. The entire EM asset class has performed strongly since the start of 2017 in one of the most unexpected developments in financial markets.
Most of the best-performing currencies this year are from developing economies. The renminbi - a major focal point of market nervousness last year – is now up slightly against the dollar after declining 7 per cent last year.
According to JPMorgan, net inflows into EM mutual bond and equity funds since the start of this year have reached more than US$32bn, with equity inflows standing at their highest level in five years and bond inflows comfortably recouping all of their losses in the weeks following the US election. In an indication of just how resilient the EM asset class has proved to the plethora of vulnerabilities and risks in markets – in particular mounting concerns about the shaky political underpinnings of Trump’s much-anticipated pro-business economic policies – inflows into EM mutual funds reached their highest level this year in the week ending March 22, according to JPMorgan.
So what accounts for the dramatic improvement in sentiment towards emerging markets?
The recent weakness of the dollar has helped significantly.
Since early January, the dollar index (a measure of the greenback’s performance against a basket of its peers) has fallen 3.5 per cent and is once again below the psychologically important level of 100. Half of the decline has occurred since the Federal Reserve’s decision on March 15 to refrain from accelerating the pace of interest rate rises this year.
Another reason behind the buoyancy of EM asset prices is a growing sense among investors that economic and financial conditions in developing nations are improving, with a stabilisation in growth (and greater policy clarity) in China and stronger balance of payments positions in many EMs, particularly in Asia.
Thirdly, commodity markets have recovered markedly over the past year or so. The Bloomberg Commodity Index is up more than 11 per cent since early March last year.
Still, storm clouds are gathering over the EM asset class – some of which never went away.
Commodity markets are under strain again, dragged down by the more than 9 per cent decline in oil prices since March 3. The Bloomberg Commodity Index has fallen 4.3 per cent since the start of this month. If oil prices decline more sharply, equity and high-yield debt markets could come under severe pressure. US “junk bonds” – non-investment grade corporate debt – are already on track to suffer their worst performance since January 2016, according to the Financial Times.
Just as importantly as far as broader sentiment is concerned, the failure of Trump on Friday to muster enough votes in Congress to pass new health care legislation could undermine confidence in the US president’s ability to marshal support for his economic policies (especially tax reform), which has turbocharged the global equity rally over the past several months.
The betting, however, is that sentiment towards EMs is likely to remain favourable provided oil prices do not collapse, growth in China holds up and the Fed does not decide to quicken the pace of rate hikes later this year.
The chances of all three conditions being met are slim. EM investors should enjoy the rally while it lasts.
Nicholas Spiro is a partner at Lauressa Advisory