Four reasons emerging markets won’t see panic this summer, like they did in 2013
‘Despite the hawkish tone from the Fed and the European Central Bank, some of the most actively traded assets in emerging markets remain resilient’
The spillover effects are already apparent.
The flurry of hawkish commentary from leading central banks in advanced economies is undermining investor sentiment towards emerging markets, the asset class that has benefited the most from the ultra-low – and in many cases negative – bond yields in developed countries.
In the week ending July 5, emerging market bond funds suffered net outflows for the first time this year, according to data from JPMorgan, with foreign investors withdrawing US$70 million compared with inflows of US$1.8 billion in the week ending June 28. Emerging market equity funds were hit hard too, with inflows tumbling to US$438 million, down from US$2.5 billion the previous week.
The prospect of tighter monetary policy in advanced economies has also put emerging market stocks under strain. The MSCI Emerging Market Index, a leading gauge of equities in developing nations, is down 1.8 per cent since June 26.
More worryingly, exchange-traded funds (ETFs), popular investment vehicles which track an index and which have become an increasingly important source of inflows into emerging markets, experienced outflows last week for the first time this year.
All of a sudden, there is talk of another “taper tantrum”, the dramatic sell-off in the summer of 2013 following the unexpected decision by the US Federal Reserve to begin scaling back its programme of quantitative easing (QE). Then, it was emerging markets which bore the brunt of the deterioration in sentiment, with bond and equity funds in developing economies suffering huge outflows in the second-half of 2013.
The central bank-driven spike in benchmark bond yields over the past fortnight is certainly reminiscent of the taper tantrum. The yield on 10-year German government debt has shot up 34 basis points since June 26 to its highest level since January 2016, while its US equivalent has surged 25 basis points.
These are dramatic moves in such a short period of time.
JPMorgan believes “the global monetary policy narrative is now at an inflection point,” leaving “plenty of scope for volatility and [emerging market] risk premia to rise in the weeks ahead as the market finds a new consensus.”
The bearish case for emerging markets suddenly looks more compelling.
Yet while it is still early days - not only is there still significant uncertainty about the scope for monetary tightening given persistently low inflation in the US and Europe, investors and traders have a long track record of misreading central banks’ policy pronouncements - comparisons with the 2013 taper tantrum are misguided.
Firstly, there are no signs of panic. Despite the hawkish tone from the Fed and the European Central Bank, some of the most actively traded assets in emerging markets remain resilient. The Mexican peso, the most liquid currency in developing economies, even strengthened against the dollar last week, while the Polish zloty, another liquid emerging market currency, was stable against the euro.
The average spread, or risk premium, on emerging market dollar-denominated bonds over Treasuries, while having risen over the past few weeks, is still more than 60 basis points lower than just after the surprise election of Donald Trump as US president last November.
Secondly, the dollar index, a gauge of the performance of the greenback against a basket of its peers, has fallen 7 per cent since early January and now stands at its lowest level since early October. This is mitigating the spillover effects from the rise in bond yields in developed markets.
Thirdly, developing economies are in better shape than they were just prior to the taper tantrum. External imbalances have improved markedly, monetary policy has been tightened in many countries, sharp falls in currencies have boosted competitiveness and the growth outlook has improved due to a pick-up in global trade.
Fourthly, and perhaps most importantly, emerging markets have become less vulnerable to outflows of foreign capital because of the growing clout of domestic institutional investors which now hold the bulk of developing economies’ debt, particularly bonds denominated in local currency. Domestic pension funds and insurance companies, especially in Asia, provide a stable and more secure source of demand for emerging market debt during periods of financial turmoil.
Still, there should be no complacency.
If bond yields continue to rise in the coming weeks, the strain on emerging markets will intensify, with sharper outflows of capital.
Yet with cumulative inflows into emerging market bond and equity funds this year still standing at over US$100 billion, according to JPMorgan, and the sense that investors may be overreacting to the shift in monetary policy, there is no cause for alarm.
Emerging markets will wobble but will remain resilient.
Nicholas Spiro is a partner at Lauressa Advisory