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.
Indeed even before concerns about China became more acute, it was increasingly unclear whether a tightening in US monetary policy - particularly one undertaken in a cautious and well choreographed manner which is precisely the strategy of Fed chair Janet Yellen - would prove as damaging to sentiment as the surprise announcement by the US central bank to start tapering its asset purchases.
According to the “2015 Spillover Report” by the International Monetary Fund (IMF), published in July, the current increase in US bond yields stems from what it calls a “real shock”, or the perception among investors that yields are rising because of a strengthening US economy. This type of shock, according to the Fund, has historically been much more favourable to EMs compared with so-called “money” or ”risk” shocks which stem from unanticipated policy actions or periods of heightened risk aversion.
“Spillovers are positive if yields go up because of good news about growth prospects in advanced economies,” the IMF says.
Bond markets are more pessimistic and are currently pricing in an unprecedentedly gradual pace of monetary tightening and a negligible increase in bond yields following the first rate hike.
So have EM investors overreacted to the shift in US monetary policy?
Quite possibly - and, what is more, they may be too bearish about China too.
While the jury is still out as to whether China’s economy will experience a hard landing, many other EMs, particularly in Asia and within the commodity complex, are already suffering harder landings mainly because of the sharp slowdown in China’s economy and the damage to sentiment caused by the unexpected devaluation of the yuan. As SLJ Macro Partners, a currency hedge fund, notes: “China’s economic landing will continue to feel “hard” from outside China.”
While it would be foolish to underestimate the degree to which confidence in Chinese policymaking has been undermined as a result of Beijing’s mishandling of both the bursting of the country’s stock market bubble and the devaluation of the yuan, the fact remains that little, if anything, has changed in China’s real economy since mid-June.
The collapse in China’s equity market has simply forced investors to pay more attention to economic and policy developments in China.
Still, the outlook for EM assets remains a bleak one.
Developing economies will remain trapped between China’s economic downturn and a tightening in US monetary policy (and, as a consequence, a stronger dollar) for a considerable period of time, putting further strain on commodity prices.
Just as worryingly, home-grown weaknesses and vulnerabilities are becoming more pronounced - notably in countries, such as India and Mexico, whose reform-minded leaders are struggling to modernise and liberalise their economies.
A sustained improvement in sentiment towards EMs is unlikely to materialise any time soon.
Nicholas Spiro is managing director of Spiro Sovereign Strategy
