Emerging markets storm back in the face of mounting risk
Inflows into EM equity and bond mutual funds in the week ending February 15 surged to $4.3 billion a dramatic shift in sentiment since’s Trump US win November
The start to 2017 has been a remarkable one for emerging markets (EM).
Ever since the Federal Reserve triggered a sharp sell-off in developing economies in May 2013 by unexpectedly announcing its decision to begin scaling back, or “tapering”, its programme of quantitative easing (QE), EM investors have taken fright at the prospect of a tightening in US monetary policy.
Since the beginning of this year, however, their instinctive fear of a more hawkish Fed has suddenly disappeared.
Last week, Janet Yellen, the Fed chairwoman, gave her strongest hint yet that the Fed would not allow itself to fall behind the curve and was sticking to its plan to hike rates three times this year.
With the Fed’s preferred measure of inflation now standing at 1.7 per cent (slightly below the central bank’s 2 per cent target) and a flurry of strong economic data last week, the odds of an increase in rates at next month’s Fed meeting have shot up to 42 per cent, up from 24 per cent at the beginning of February.
Yet EM investors are unperturbed.
According to JPMorgan, inflows into EM equity and bond mutual funds in the week ending February 15 surged to $4.3 billion – a dramatic shift in sentiment compared with the eight-week-long streak of outflows that followed the upset victory of Donald Trump in the US presidential election in early November.
Cumulative inflows into EM equity and bond mutual funds since the beginning of this year have reached nearly $17.5 billion, according to JPMorgan. This is the strongest start to the year for EM fund flows since 2013.
Having fallen by 7 per cent in the week following Trump’s victory, the MSCI EM Index, a leading gauge of EM equities, gradually recovered and has shot up by 11.5 per cent since Christmas to its highest level since July 2015.
Many EM currencies, including some of the most vulnerable ones, have also strengthened against the dollar since the start of 2017. The South Korean won and the Indonesian rupiah have gained 4.8 per cent and 1 per cent respectively, while the Brazilian real and the Polish zloty have risen 5 per cent and 2.3 per cent respectively. Even the Turkish lira, the worst performing EM currency of late, has begun to strengthen, rising by a remarkable 6.2 per cent since late January.
So what’s accounting for the buoyancy of EM assets, especially given persistent fears about Trump’s protectionist and anti-trade rhetoric, an escalation in political risk in the eurozone centred around France’s upcoming presidential election and, most strikingly, investors’ increasing confidence that the Fed will raise rates this year?
There are three factors at play:
● The dollar itself has weakened markedly since early January, with the dollar index (a gauge of the greenback’s performance against a basket of its peers) falling 2.3 per cent, relieving some of the strain on EM currencies and local bonds.
● More importantly, fears about China’s economy and policy regime have abated significantly over the past year, triggering a rebound in commodity prices, a crucial driver of sentiment towards EMs. Having hit a record low in mid-January 2015, the Bloomberg Commodity Index has since risen 20 per cent, with Brent crude, the international oil benchmark, up 93 per cent to nearly $56 a barrel.
● And just as importantly, despite all the talk of a “great rotation” out of bonds and into equities as Trump’s reflationary economic agenda heightens expectations of faster rises in interest rates, the yield on benchmark 10-year Treasury bonds currently stands at just 2.4 per cent - nearly 20 basis points lower than in mid-December and in the face of further evidence from the Fed that it has adopted a more hawkish outlook.
It is this third factor that casts the most doubt on the sustainability of the rally in EM assets.
Although bond investors have become more confident that the Fed will raise rates this year, there is still a sizeable disconnect between markets and the Fed, mostly because investors seriously question whether Trump will be able to implement a hefty fiscal stimulus package.
Even though Yellen confirmed last week that rate hikes are likely to be undertaken irrespective of the trajectory of fiscal policy, bond investors remain sceptical.
If the Fed surprises many investors by raising rates at its next meeting on March 14-15 and sounds a decidedly hawkish note, bond yields are likely to rise significantly, putting renewed strain on EM assets.
Still, the mere fact that EMs have so far proved resilient to Britain’s decision to leave the European Union and Trump’s triumph is remarkable in itself.
Nicholas Spiro is a partner at Lauressa Advisory