Macroscope | Emerging markets trapped between China’s woes and US Fed tightening

In May 2013, the unexpected announcement by the US Federal Reserve that it planned to start winding down, or “tapering”, its programme of quantitative easing (QE) triggered a sharp sell-off in emerging markets (EMs). Investors feared that the removal of one of the most important pillars of support for so-called “risk assets” would suck money out of developing economies - particularly those countries which relied heavily on speculative inflows of foreign capital to fund themselves.

Over the past two years, the prospect of the first rise in US interest rates since 2006 has weighed heavily on sentiment towards EMs. While EM equity funds attracted inflows of more than US$50 billion in 2012, they suffered outflows of $25 billion and $28.5 billion in 2013 and 2014, according to JP Morgan.

This year, outflows from EM equity funds already amount to nearly $45 billion. However, the bulk of the redemptions have occurred since June following the bursting of China’s equity market bubble.

In the last three months, the Fed - which may decide to raise rates at a pivotal policy meeting next week (markets are putting the odds of a hike at roughly 30 per cent, down from more than 50 per cent in mid-August) - has been playing second fiddle to China when it comes to the drivers of sentiment towards EMs.

According to the latest Global Fund Manager Survey by Bank of America Merrill Lynch (BAML), more than 50 per cent of investors now believe a recession in China poses the biggest “tail risk” for markets. A further 15 per cent believe a full-blown EM debt crisis is the biggest risk, while only 10 per cent of respondents believe the Fed has fallen behind the curve.

Make no mistake, policy and economic uncertainty in China has suddenly become the focal point of market anxiety about EMs.