The current selloff in Emerging Markets (EM) may be peripherally related to Federal Reserve (Fed) tapering, but any linkage is more psychological than mechanical. In general, Fed tapering is expected to result in a renormalizing of bond yields (i.e. the 10-year Treasury working its way back to 3.5% or a little higher this year), but the Fed is still easing – just a little less aggressively – and they are not tightening.
State of Emerging Markets
The unrest in Ukraine and Thailand, like the Middle East (Syria/Iran) stress, has virtually nothing to do with Fed policy. The weak currency problems in Venezuela and Argentina are the result of long-standing, ineffective government policies in those countries. To the extent that their current problems are related to Quantitative Easing (QE) tapering, it is only through the ‘when the tide goes out, you get to see who was skinny dipping’ mechanism. The soft Chinese PMI (Purchasing Managers Index) data, an indicator of the economic health of the manufacturing sector, did not spark the selloff – the Chinese stock market performed well last week. Instead, it was Argentina’s (long overdue) currency devaluation that really spurred the market’s flight to safety.
Without flagging the taper as the primary cause of last week’s selloff, it is the Fed that encouraged massive capital flows into EM in their ‘search for yield’ phase (and for their current withdrawal as rates normalize). Remember Brazil’s Finance Minister complaining about a ‘currency war’ when EM currencies were rising? Now they are falling. That said, fear has replaced greed as the market’s dominant emotion, and valuations are not important in the near-term. A Fed decision to pause the taper probably would not change that. Along those lines, the rally in the yen (in the face of extremely aggressive QE by the Bank of Japan) supports the view that we are seeing a flight to safety, not (just) a dollar rally because of the taper.
Looking forward, we believe stronger Euro Zone and U.S. GDP and continued growth of China GDP would benefit EM economies most – an outcome that would lead to more tapering and, eventually, a higher fed funds rate. Low U.S interest rates, which are now rising, may lead to capital flows that drive short-term returns, but growth is what matters over the intermediate-longer term.
In general, we think EM equity valuations are relatively cheap, but not rich. In many cases, EM sovereigns are generally offering attractive yields relative to Developed Markets (DM) sovereigns, especially when factors like debt/GDP fiscal and trade balances (especially unfunded post-retirement and entitlement liabilities) are considered.
The Bottom Line
Quantitative Easing may have contributed to capital market imbalances (overvaluation) and enabled some countries to pursue unsustainable policies a little longer than otherwise. The normalization in the U.S. bond market is encouraging capital flows to move in the other direction. We believe further tapering creates a headwind for EM, but valuations are generally not excessive – arguably, even inexpensive – so markets should find a base when the current flight to safety abates.