Brexit and Trump cast favourable light on emerging markets
Money pouring into EM mutual equity and bond funds, says JP Morgan, with net flows reaching nearly $65bn this year, nearly all of them since Brexit
On Monday, the renminbi fell the most in four months as China’s central bank set the midpoint around which the onshore rate can trade above the psychologically important level of 6.7 to the dollar for the first time since 2010. Both the onshore and offshore rates are now trading at six-year lows and are among the worst performing currencies this year.
If this had happened in early January, when China was the focal point of market nervousness, the move would have rattled investors and led to a sharp sell-off in emerging market (EM) assets.
Yet as traders and investors in London and New York returned to their desks earlier this week, the renminbi’s decline was the least of their concerns.
Instead, it is political risk and financial vulnerabilities in advanced economies, particularly in Britain and the US, that are front and centre for markets these days.
The facts speak for themselves.
Since Britain’s shock decision to vote to leave the European Union (EU) on June 23, the MSCI EM index, a leading gauge of stocks in developing economies, has risen 8 per cent. Investors have poured money into EM mutual equity and bond funds.
According to JP Morgan, cumulative net flows have reached nearly $65 billion this year (compared with outflows of nearly $80bn last year), with nearly all of the inflows occurring since the Brexit vote.
While this is partly due to the “TINA” mantra – there is no alternative – which is being used to describe the increasingly desperate search for higher-yielding assets amid a plunge in bond yields in advanced economies, it is also part of an ongoing reassessment of the risks and vulnerabilities in developed nations versus those in EMs.
According to Ashmore, an EM-focused asset manager, advanced economies “are looking more and more like economic and political ‘freak shows’. Policymakers appear to be in denial about the seriousness of the problems and politicians are rushing headlong into populism and protectionism.”
The sharp fall in the pound, triggered by fears that UK premier Theresa May’s government is pushing for a “hard” Brexit, suggests that the UK’s decision to leave the EU has ushered in a new and more dangerous phase for markets in which political developments have a much stronger bearing on sentiment.
Sterling, one of the world’s most actively traded currencies, has become the purest expression of investors’ fears about political risk in advanced economies.
If Donald Trump were to win the US presidential election on November 8, the influence of political risk in developed economies on markets would go into overdrive, leading to a severe deterioration in sentiment across asset classes.
Indeed Ashmore rightly notes that investor jitters about advanced economies are much more dangerous because of the significantly more liquid and interlinked nature of developed nations’ financial markets.
“Investors are disproportionately concentrated in these markets. Developed markets are substantially overweighted versus EM in [investors’] portfolios. This means that if one market goes under, investors [will] take profits in others and hence spread contagion like wildfire throughout the entire developed market complex.”
Risks in EMs, on the other hand, are more country-specific and less prone to morph into a systemic crisis.
If the collapse in sterling, which on Wednesday appeared to be stabilising having tumbled 18 per cent against the dollar since the Brexit vote, were to lead to severe inflationary pressures in Britain and cause a sharp sell-off in the bond market – a scenario which became more likely in the last week or so – then broader sentiment could deteriorate much more sharply.
Still, while the biggest risks facing markets right now are in the UK and the US, EMs are by no means safe havens.
On Tuesday, political risk in South Africa escalated when prosecutors summoned Pravin Gordhan, the country’s respected finance minister, to charge him with fraud in a long-running dispute thought to be part of an attempt by Jacob Zuma, South Africa’s embattled president, to undermine the independence of Gordhan’s ministry.
Yet South Africa’s woes are not systemic.
China’s, on the other hand, as a new working paper from the International Monetary Fund (IMF) notes, are having a much stronger bearing on sentiment, with financial spillovers to the rest of emerging Asia likely to rise further in the coming years due to “tighter financial linkages”, including “the ongoing internationalisation of the renminbi”.
Investors may be fixated on sterling, but the decline of the renminbi could yet prove more consequential.