Grad­ual Fed path is aid to EM rally, not hin­drance

Gulf Times Business - - BUSINESS -

Emerg­ing mar­kets are un­der siege from many threats but the Fed­eral Re­serve isn’t one of them. Even as the US cen­tral bank con­tin­ues on its rate­hike path, the risk of cap­i­tal flight from de­vel­op­ing-na­tion as­sets has di­min­ished, money man­agers from Bank of Amer­ica Mer­rill Lynch to JPMor­gan Chase & Co say. That view is backed by his­tory, which shows emerg­ing mar­kets re­main re­silient to Fed tight­en­ing as long as it’s or­derly and well-com­mu­ni­cated.

Riskier as­sets in­clud­ing emerg­ing mar­kets re­main vul­ner­a­ble to global fund out­flows dur­ing times of Fed tight­en­ing as in­vestors seek safer in­stru­ments such as US Trea­suries. That was the rea­son Ben Ber­nanke’s 2013 com­ments on with­drawal of Fed stim­u­lus sparked panic sell­ing that came to be known as the “taper tantrum.”

Yet, in­vestors who stuck to that view lost out on emerg­ing-mar­ket ral­lies re­peat­edly - like in 2006 and 2016, when de­vel­op­ing-na­tion as­sets ad­vanced in the wake of ris­ing US in­ter­est rates.

His­tory sug­gests that a ro­bust US econ­omy is more im­por­tant to emerg­ing­mar­ket for­tunes than fluc­tu­a­tions in fund al­lo­ca­tions. That re­la­tion­ship was ev­i­dent when the MSCI Emerg­ing Mar­kets In­dex, which was ral­ly­ing on trade op­ti­mism, main­tained its gains even as the official jobs data showed US em­ploy­ers hired more than fore­cast in Oc­to­ber. A strong econ­omy should sup­port Fed tight­en­ing, a threat to riskier as­sets, but last week’s news was taken as a com­fort­ing fac­tor amid a global growth slow­down.

And that’s not just stocks. Emerg­ing­mar­ket bonds also defy the con­ven­tional wis­dom that they must fall, send­ing yields higher, in times of US yield in­creases to main­tain the ex­tra re­turn they of­fer to at­tract in­vest­ments. There have been more than 15 oc­ca­sions since 2005 when that did not hap­pen.

For in­stance, in June 2007, in­vestors ac­cepted a risk pre­mium of as low as 161 ba­sis points when the 10-year Trea­sury yield was 5.29%. Con­trast that with now when the spread is about 365 ba­sis points and the US rate is 3.11%, and de­vel­op­ing­na­tion bonds be­gin to look cheap.

A re­cov­ery in emerg­ing mar­kets re­mains frag­ile as US-China trade ten­sions, re­ces­sions in a grow­ing num­ber of emerg­ing economies and po­lit­i­cal un­cer­tainty un­der­mine the case for riskier as­sets. But in­vestors give at least four rea­sons why a grad­ual Fed pol­icy tight­en­ing is not one of the risks:

Risks priced in: Emerg­ing-mar­ket stocks have al­ready en­dured a $5.5tn rout this year, and dol­lar-de­nom­i­nated bonds have seen their risk pre­mi­ums jump by about 30%. Mar­ket prices al­ready re­flect the worst-case sce­nario aris­ing not only from Fed hikes, but also from the USChina trade war and the dol­lar’s strength, says Kathryn Rooney Vera, head of global re­search at Bulltick Cap­i­tal Mar­kets.

“I’m not wor­ried about it un­less the Fed were to jack up rates more than four times (in the next 12 months)”, she says.

De­vel­op­ing economies are also on a much more pre­dictable path of growth than in the past, and can ad­just to a more nor­mal mon­e­tary-pol­icy en­vi­ron­ment in the US. “If you’re in an en­vi­ron­ment of de­cent global growth, mar­kets can with­stand rate hikes,” says Rashmi Gupta, a port­fo­lio man­ager at JPMor­gan. “The fear is if the Fed raises rates too quickly in an en­vi­ron­ment when growth is weak.”

US growth sup­port: With every rate hike, the Fed re­it­er­ates its faith in the ro- bust­ness of the US econ­omy, which is good news for emerg­ing economies. De­vel­op­ing na­tions send as much as 17% of this ex­ports to Amer­ica, gain­ing a $1.3tn growth boost.

“Ac­tiv­ity in the US is strong, rates are still low by his­tor­i­cal stan­dards, and the de­mand for goods and ser­vices is very strong,” says Mor­gan Hart­ing, se­nior port­fo­lio man­ager at Al­lianceBern­stein Hold­ing LP. That means “de­mand for goods pro­duced in EM coun­tries is also strong and that’s good for com­pany earn­ings and rev­enues of those gov­ern­ments.”

Case for grad­u­al­ism: The US econ­omy may be strong but not so strong as to en­cour­age the Fed to speed up the path of nor­mal­i­sa­tion.

Data re­leases in­clud­ing a worse-thanex­pected dip in hir­ing dur­ing Septem­ber and a third-quar­ter gross do­mes­tic prod­uct growth that was heav­ily de­pen­dent on in­ven­to­ries have spurred ex­pec­ta­tions the Fed will stick to its pol­icy of grad­ual rate in­creases.

“When we look at this ques­tion through the lens of in­fla­tion and the la­bor mar­ket, there is lit­tle case that the Fed is be­hind the curve on its macro fore­casts.” IIF chief econ­o­mist Robin Brooks said.

The knee-jerk re­ac­tion of mar­kets to Ber­nanke’s com­ments five years ago has made the Fed more cir­cum­spect in wind­ing down stim­u­lus, ac­cord­ing to Mer­ill Lynch global econ­o­mist Aditya Bhave.

“They want ev­ery­one to un­der­stand that rate hikes are the pri­mary tool by which they’re go­ing to tighten pol­icy be­cause mar­kets un­der­stand how rate hikes work through the econ­omy much bet­ter than quan­ti­ta­tive eas­ing,” he says. “They want to un­wind QE in a man­ner that’s not jar­ring to the mar­kets if pos­si­ble, and they’ve been pretty suc­cess­ful so far.”

Cheap val­u­a­tions: Value hunters have plenty to pick in emerg­ing mar­kets - from stocks that trade at the same val­u­a­tions as 4 1/2-years ago to bonds that of­fer 1.5 per­cent­age points of ex­tra re­turn com­pared to the start of the year and many cur­ren­cies near record lows.

“EM is get­ting crushed,” said Rooney Vera of Bulltick. “There’s a lot of mis­pric­ing right now and I’m hon­estly ex­cited about it be­cause we can make money for our clients.”

The US Fed­eral Re­serve build­ing in Wash­ing­ton, DC. Even as the US cen­tral bank con­tin­ues on its rate-hike path, the risk of cap­i­tal flight from de­vel­op­ing-na­tion as­sets has di­min­ished, ac­cord­ing to money man­agers.

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