The Emerging Markets rollercoaster... where to now?
ref :- "Emerging markets, the Fed, and the virus" , "Unhedged" newsletter, the Financial Times
A great deal happened in Emerging Markets during that long period whilst we were away, and it strikes us that we haven't really pointed you towards anywhere that directly addressed that huge and complicated subject since we got back. Attention has been focussed on the prospect of climbing inflation, and the likely responses in central bank monetary policy to it... most crucially of course by the US Federal Reserve. But then the future for Emerging Markets and US rates is always inextricably linked, even if a cocktail other factors are also at play when trading EM markets.
So it's back to Robert Armstrong's newsletter, and his opinion of what has been behind the strong EM performance during the pandemic and of what may decide where we go from here.
One thing to always bear in mind when taking an overview of EM performance is that very often the progress or otherwise of a wide range of countries (which may be in very different states of health) are lumped into various EM indices. Since those indices mostly include China, those indices are skewed in that direction. There is understandable debate about the helpfulness of still including the planet's second largest economy in an EM index - is it still "emerging", or should we consider it well and truly "emerged”? - but while that situation remains there are obvious caveats to be observed. Most crucially, if taking a view on the assets of a particular nation or region, make sure you look beyond any pan-EM index and consider the factors particular to that area.
Anyway... Mr Armstrong tells us that EM stocks have performed strongly since March last year (after an early blip), and much of the reason for that is the close link to the performance of EM currencies. If EM investors were buffeted by currency weakness for decade or more, the pandemic era has seen the EM currency index perform strongly as the US dollar fell on the back of near-zero official short-term rates interest rates, which have moved into negative territory further down the curve once inflation is taken into account, and by the remarkable rally in commodity prices.
Remembering that caveat, the index figure hides some pretty arresting contrasts between individual nations. China and those most closely involved in its supply chain (e.g. Taiwan, South Korea) have performed best, reflecting a quick and comparatively successful handling of the pandemic. At the other end of the scale, Turkey remains a basket-case, the Turkish Lira continually undermined by a president who is a serial sacker of central bank governors who might attempt to raise interest rates to fight that country's rocketing inflation. Surprisingly perhaps given the pandemic, the Indian rupee has fared not too badly and even some pretty disastrous handling of the pandemic in Russia and Brazil has been mitigated by the strength in commodities.
Another reason for EM currency strength has been (Turkey aside) a willingness to start raising rates to counteract rising inflation forces. That's not surprising (though faintly reassuring) when one considers how inflation has damaged EM currencies (and therefore assets and ultimately economies) in the past. But if you're talking inflation-induced rate rises, you've got to ask yourself what might happen if, or rather when, the US starts along that path?
This subject is the main reason why many are wary of EM assets. The US Fed is already beginning to talk about tapering asset purchases even if actual interest rate rises look to be some way off yet. People say that investors' memories are short, but you can bet your bottom dollar that they'll all remember the Taper Tantrum of 2013. Some poorly-communicated more hawkish comments by Fed boss Ben Bernanke about tapering and the prospect of higher rates induced a melt-down in bond markets, which took other assets with them. The effect was global, but the worst hits were in emerging markets.
If you believe that a strong dollar and rising rates are likely to coincide with a fall in commodity prices (which have already shown signs of topping), well... you'd be right to be wary at the very least. As Mr Armstrong points out, such a fall in commodities would be pretty disastrous for the likes of Brazil and Russia, and China's recent move to tighten credit conditions makes that more rather than less likely.
On a more optimistic note, for EM markets, the Fed itself points out that not all rate-tightening cycles are accompanied by damage to emerging markets. Its assertion is that if the cycle is a response to economic growth (which encourages imports) rather than a reaction to inflation worries, EMs can still prosper... and it uses the mid-2000s cycle as an example.
The jury is still out on which kind of tightening cycle it will be... or even if we're certain to see one worth the name at all. If that's the case, and conceivably even if it’s not, the future for EMs is likely to be decided by the great issue of the era... COVID 19. We MIGHT see widespread vaccination ensuring continued growth on a global scale and the future could be rosy. On the other hand, to paraphrase Simon Quijano-Evans of Gemcorp who is quoted in the piece, many EM nations in particular are way behind on meaningful vaccination programmes, so we MIGHT also see increasing rates of illness, deaths and economic shutdown. If that should be accompanied by falling commodity prices, well... watch out.