Doused with dollars

Doused with dollars

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The received wisdom is that the fortunes of emerging market equities slavishly follow global liquidity conditions. 

This perception is that such markets are pumped up by monetary expansion, as capital spreads out in search of decent returns, and fall victim when it withdraws. But while this truism has held in recent years it does necessarily follow that the relationship is permanent.

The biggest determinant of global liquidity environment is of course US monetary policy, from conventional interest rate adjustments to the quantitative easing programme it suspended in 2014. 

Although the central banks of major economies such as Japan and the eurozone are still firmly in easing mode, speculation over the timing and pace of US Federal Reserve tightening continues to cause volatility in emerging markets. It has contributed to emerging market equities underperforming for much of the last five years.

While the path of US rates is almost certainly upwards – barring a major shock – expectations have been tempered somewhat during 2016, with weak employment data in June further knocking confidence. 

Alongside further QE announcements from the EuropeanCentral Bank and Bank of Japan, it has contributed to a period of stronger relative performance for emerging market equities starting in the early months of 2016.

This all suggests that global liquidity conditions remain a key determinant of emerging market equity performance. But it is less clear that the strength of this effect will persist if or when the global economy really gets going.

Global trends 

“Low interest rates being increased, even a little, has mattered,” says Marteen-Jan Bakkum, senior emerging markets strategist at NN IP. “All markets had benefited from the idea that interest rates would be low forever. If markets believe that interest rates will have to move higher than expected, it puts whole areas under pressure.”

Referring to a recent gyration, he says “the market has once again become worried that the Fed will have to hike – it wasn’t priced in and we have seen the pressure on emerging markets.” 

There is a solid, logical reason for markets moving in this way; a relative improvement in the returns available in the US will inevitably draw flighty capital from emerging to US markets, wherever its origin. 

Some emerging markets rely on international capital flows to fund fiscal and current account deficits, or simply to boost inward investment, in which case there is the potential for additional damage. The IMF estimates that emerging markets received $4.5trn of gross capital inflows between 2009 and 2013 – so there is plenty to potentially unwind.

However, the dynamic is nuanced. Dr Patrick Mange, head of APAC & emerging markets strategy at BNP Paribas Investment Partners, points out that emerging markets have not always followed moves in global liquidity: “Prior to 2009, emerging markets were suffering, but all markets were suffering, so it was more a question of degree. Equally, they did not generally benefit from the expansion in global liquidity seen since 2011.”

Restricting options

Emerging markets also feel the effects of US rate rises beyond the impact on their currencies and outflows of capital. 

Emerging market corporate and government borrowing in US dollars has expanded considerably in recent years, as investors demand lower returns when local currency risk is removed. 

Figures from the Bank for International Settlements reveal that aggregate dollar-denominated emerging market borrowing has doubled to $4.5trn in the past five years. 

The dollar’s strong appreciation ahead of expected rate rises has therefore increased the indebtedness of corporates in local currency terms. It is a classic emerging market debt problem – indebtedness increases at precisely the point when the economy deteriorates, potentially leaving obligations unaffordable.

The strengthening dollar also restricts the flexibility of emerging market central banks to adjust their own monetary policy – reducing rates at a time when the Federal Reserve is tightening would exacerbate capital outflows and could eliminate the intended simulative effect and even be counterproductive.

Emerging market central bank liquidity, using a money supply metric created by CrossBorder Capital, while still slightly tight by historic standards,has rebounded from the November/December 2015 lows that roughly coincided with the US dollar’s peak. The latest US dollar reversal may therefore be helping emerging market policymakers to ease. 

There are also other connected factors at work, such as a risk-on/riskoff dynamic that sees assets rushing between return-seeking assets and being harboured in safe-havens. 

Mange says that the perception that emerging market equities are at the riskier end of the spectrum is an important factor in determining their outlook. “Asset allocators have a view on where is more or less defensive,” he says. “The US and Japan are considered more defensive, while India, China, Russia or Turkey are considered less so.” 

Mange also believes that liquidity obscures normal market signals, with a squeeze exacerbating short-term movements. “In many cases, the usual signals are completely worthless… liquidity has reduced the time horizon of investors. Sentiment changes in the market are occurring much more often. Look at how many times the market has changed its mind on the Fed function. This is where liquidity is important.” 

“Fundamental aspects may be more in evidence when monetary policy is considered more normal, but what is now normal? It is not what we have today, but normality is a relative concept.” 

Some countries are more vulnerable than others. “It will depend a lot on the budget or current account deficit,” Bakkum at NNIP says. “Many emerging market countries are in need of foreign capital, though there are some that can do well without it.” 

There are countries that didn’t experience significant foreign inflows in boom years, which are therefore less vulnerable – India would be one example. Thailand also has a strong domestic investor base, which leaves it less reliant on the ‘kindness of strangers’. By contrast, South Africa, Turkey, Korea and Malaysia look more susceptible. In China, he adds, strong domestic credit growth has been helped by foreign inflows. 

“This is difficult to sustain. Equity markets have to adjust and this is why we have a significant negative position in markets that are most in need of foreign capital and where credit growth is highest.” Role of active managers If it is true that global liquidity is having a strong bearing on emerging market beta – increasing the correlation between stocks – the ability of active managers to add alpha is compromised. 

It undermines the oft-repeated argument of active managers that their fundamental analysis and stock-picking skill is particularly effective in the developing world. However, Ross Teverson, manager of the Jupiter Global Emerging Markets fund, argues that there is still differentiation between stocks, sectors and countries. 

He says: “Certainly, in the short-term, markets where there is very high stock correlation are not the best environment for stock pickers and there are times when the market thinks of emerging markets as a homogenous block. 

“However, different markets are impacted in different ways by changing liquidity conditions. We should also ask why US rates are moving higher. Is it because there is a stronger domestic economy? This is positive for some emerging markets, such as Asian exporters.

 In this case, the positives demand should outweigh the negatives from the interest rate environment. “In Taiwan and South Korea, we can find a number of companies that are likely to perform well in this environment. 

A lot of companies benefit from a stronger demand backdrop,” he adds, citing companies supplying to US consumer goods companies as an example. 

Equally, although emerging markets as a whole have been weak until relatively recently, there have been outlier countries. India, for example, saw a strong bounce on the election of prime minister Narendra Modi. 

Teverson notes that markets are starting to differentiate more between companies and sectors as the outlook for emerging markets as a whole has improved. Indeed, there are signs that where investors are returning to emerging markets they are doing so selectively. 

For example, David Jane, co-head of multi-asset investment at Miton, has recently made an adjustment: “We have added a little to our India weighting, seeing this as a hedge within emerging markets. It is a self-reliant economy, and a net importer of commodities and oil. We have also added to the more liquid emerging markets, such as Mexico and Brazil. 

We still think the question of whether we have turned the corner in resources is too difficult to answer, so haven’t bought the big resources companies such as Petrobras.” Liquidity has exerted a strong effect on the direction of emerging market equities to date and they may still be vulnerable to shifts in expectations for monetary policy. 

But the fundamental characteristics of individual countries and companies are resuming a more important role, possibly signalling a new phase in the progress of emerging markets. 


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