How the US dollar could turn emerging market fortunes around if the Chinese yuan maintains its value
Nicholas Spiro says a stabilising US dollar and the sell-off in emerging market stocks last quarter means developing economies could be attractive once again
The last quarter was one that emerging market investors would rather forget. According to Bloomberg, the currency, equity and bond markets of developing economies suffered their worst three-month period since the third quarter of 2015 when emerging market assets bore the brunt of the sell-off stemming from the surprise yuan devaluation.
A toxic combination of an abrupt tightening in financial conditions, an end to the period of synchronised global growth and a dramatic escalation in tensions over international trade has led to a sharp deterioration in market sentiment. According to data from JPMorgan, emerging market bond and equity funds have suffered outflows for the past 11 weeks, while the JPMorgan Emerging Market Currency Index, a leading gauge of currencies in developing nations, plunged 9 per cent last quarter, its sharpest fall since 2011.
Yet, over the past month or so, the most important financial vulnerability in emerging markets has become less acute. The rally in the US dollar has lost momentum and has even begun to unwind slightly. While the dollar index, a measure of the performance of the greenback against a basket of other currencies, surged 6 per cent between mid-April and the end of May, it has since proved volatile, and has fallen a tad since the end of last month.
To be sure, it is too early to call time on the dollar’s ascent, not least given the increasingly hawkish signals from the Federal Reserve. However, the recent stabilisation of the greenback is noteworthy and, if sustained, could help turn the tide in the outlook for emerging markets – especially given the fact that valuations in developing economies are starting to look more attractive following several months of sharp price declines.
The main reason the dollar’s rally has stalled is the sudden rebound in Europe’s economy, particularly in Germany. This is allaying fears that the recovery in the euro zone was in danger of being snuffed out. In a report published last Friday, JPMorgan noted that Europe has supplanted the US over the past several weeks as the region where economic data is beating market expectations, challenging “the presumption of US economic exceptionalism.” The stronger data out of Europe has lifted the euro, putting the dollar under strain.
The respite provided by the volatile greenback has already had an impact on sentiment towards developing economies. According to Bloomberg, so-called carry trades – borrowing more cheaply in dollars to purchase higher-yielding emerging market currencies – have turned profitable again, having been loss-making in the second quarter of this year.
More importantly, the uncertain outlook for the dollar has focused attention on the valuations of emerging market assets, particularly equities, which have become significantly cheaper since the sell-off gained momentum in April.
The more than 16 per cent slide in the MSCI Emerging Market Index, the leading gauge of stocks in developing economies, since the end of January has wiped off more than US$2 trillion from the value of emerging market shares. According to MSCI, the forward price-to-earnings ratio – a popular valuation metric – for the index has fallen to 11.2, down from 13.3 at the beginning of this year and below its historical average of 11.4.
While emerging market stocks are still more expensive than in early 2014 in the aftermath of the “taper tantrum”, they are now trading at a steeper discount to Japanese and European shares, whose forward price-to-earnings ratios were almost on a par with those in developing economies at the start of this year.
The question, however, is whether emerging market equities are sufficiently cheap to shield investors against further price declines, especially given the increasing strain on markets stemming from the escalation in trade tensions.
While the answer depends on a number of factors, the most important one is sentiment towards China which has reached an inflection point after two years of calm.
If the sharp declines in the yuan and Chinese stocks over the past several weeks persist and begin to have a more severe impact on broader markets, investors will not be tempted by cheaper valuations and will instead start fretting about a repeat of the 2015 sell-off and the damaging effect this could have on global growth.
For the time being, markets are downplaying concerns about financial stability in China given the absence of large capital outflows. Provided investors continue to differentiate between the current tremors and the 2015 sell-off, and as long as the dollar remains stable, emerging market stocks could soon be ripe for bargain-hunting.
Nicholas Spiro is a partner at Lauressa Advisory