- EMs are losing their gloss vis-a-vis Developed Markets, especially the USA
- Sell EM FX vs the US$ (like the AUD and NZD) but wait for better entry point
- Sell EM equities but wait for better entry point
- We assume there will be a bounce due to the speed and size of the current sell-off in EM FX and due to the re-pricing of QE tapering time scales that is taking place as we speak
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We, here at Archbridge Capital, enjoy talking about themes in the market place. Themes are in effect describing market dynamics that should, in our view, continue for a reasonable amounts of time. They are in effect medium to longer term macro-economic movements which express themselves in price movements. One such theme, as our established readers already know, is that interest rate levels in the US, which have been suppressed by massive amounts of QE over the last few years, cannot reasonably be expected to remain at these levels. Please refer to "There is treasure in thoseTreasuries" April 4, 2013.
Another such theme is one that we have touched upon in "Emerging markets be aware" March 21, 2013 but not expanded on in detail. We shall take this opportunity to do so.
For the years after the ailing 2008 crisis which has affected mainly the developed world due to their highly developed derivatives markets, meant that major Western block countries like the USA and the EU have suffered severe economic setbacks and rising unemployment. The central banks have reacted by reducing their interest rates and by pumping money into the economic system in order to kick-start their economies and prevent a deflationary depression. In the larger picture this has been avoided and instead of a depression we saw what is now called the 'Great Recession' of the last years.
In the USA interest rates have been reduced to 0.25% and are expected to remain there at least until the end of 2014 or even 2015. The Fed's expansion of its balance sheet has caused longer term interest rates to also be subdued, the US 10 year rates have traded down to 1.4% and only recently have climbed above 2%, which are still very low levels for a country that is growing by around 2% with an inflation rate of 1-2%. US economic growth and inflation figures would under 'normal' circumstances, without Fed intervention (QE) warrant interest rates around 3.5% in the 10 year region.
In the USA interest rates have been reduced to 0.25% and are expected to remain there at least until the end of 2014 or even 2015. The Fed's expansion of its balance sheet has caused longer term interest rates to also be subdued, the US 10 year rates have traded down to 1.4% and only recently have climbed above 2%, which are still very low levels for a country that is growing by around 2% with an inflation rate of 1-2%. US economic growth and inflation figures would under 'normal' circumstances, without Fed intervention (QE) warrant interest rates around 3.5% in the 10 year region.
The USA economy is increasingly showing signs of strengths and these would be even more pronounced had the US government not insisted on implementing its fiscal tightening programmes (i.e. sequestration and tax increases). But even with those headwinds the underlying US economy is growing and improving and we expect to see even stronger US economic growth figures in the region of near 3% in 2014. It is clear that the Fed has noticed these improvements and is beginning to contemplate when QE measures should be scaled back ('tapering' is the word du jour). All this means is that some time in the future, and our guess is in Q1 2014 the massive QE programmes of the US will be scaled back. This will have some severe influences upon the financial markets.
The logical place to start analysing the impact of reduced QE would be to look at the key beneficiaries of the QE programmes and then to determine if a reversal of QE would mean that those beneficiaries would also be the main losers in such a scenario.
The key winners of QE programmes and a troubled USA, EU have been the EMs, which had higher interest rates and obtained vast funds into their economies, as 'hot money' or FDI (which in some countries like Turkey amounted to privatisations and sales of existing companies, rather than greenfield start ups). A lot of Emerging Markets, like Turkey for instance, have then attributed these macro economic developments to their governments (and of course the governments have done their best to take credit for them). It is clear, however, that world economic circumstances were responsible for the stellar growth rates of those countries since 2008.
In fact mismanagement and governmental mis-allocations have left the underlying economies of some emerging markets, like Turkey, in weaker conditions over those years. Only massive capital inflows due to the above mentioned world circumstances have to date hidden these underlying woes. Investors en masse left the USA for instance in order to capture the better yield in Emerging Markets (EMs) and participate in their currency appreciation at the same time. In short, investors left low yielding, monetising countries for greener pastures.
In fact mismanagement and governmental mis-allocations have left the underlying economies of some emerging markets, like Turkey, in weaker conditions over those years. Only massive capital inflows due to the above mentioned world circumstances have to date hidden these underlying woes. Investors en masse left the USA for instance in order to capture the better yield in Emerging Markets (EMs) and participate in their currency appreciation at the same time. In short, investors left low yielding, monetising countries for greener pastures.
However, now that the giants are beginning to grow again, where the US recovery seems to be firmly in place, were QE reduction is debated, where interest rate normalisation is only a few years away it seems reasonable that investors are reconsidering. Especially because the attractive yields in EMs have all but disappeared and yield differentials with more robust countries are increasingly and steadily narrowing.
The appreciating currencies of the EMs are beginning to cause those countries substantial problems since a lot of them are strongly export-dependent countries with large current account deficits. In other words the EMs require a lower exchange rate in order to help their own economic growth rates which are ailing and are reducing interest rates even further in order to achieve this.
The appreciating currencies of the EMs are beginning to cause those countries substantial problems since a lot of them are strongly export-dependent countries with large current account deficits. In other words the EMs require a lower exchange rate in order to help their own economic growth rates which are ailing and are reducing interest rates even further in order to achieve this.
With the attractiveness of EMs disappearing and the attractiveness of less risky, better rated industrialised countries increasing it seems reasonable to expect that investors will continue to move their funds back to the USA and in future to the EU (once the EU has overcome its own recessionary pressures). These flows should make EMs less attractive for investors going forward and cause their currencies to depreciate, which is a movement that is taking place as we speak, but may well be in its infancy since QE had pushed funds into EMs for years, trippling some of the EMs illiquid markets in the process (for instance longer term bond markets). One would reasonably expect that this unwinding process will take a longer period than the month or so that we have experienced so far...
How best to implement this theme into a trading strategy?
One could simply short the EM currencies versus the US$ for instance, while we would recommend doing so on a bounce, since in the short term a lot of the EM currencies seem oversold, as the markets were pricing in the possibility that QE tapering would begin as soon as the June Fed meeting, which we believe is too soon.
How will the EMs react, however, to a substantial fall in the exchange rate?
At first they will be relieved and in fact in Australia or New Zealand for instance we are seeing their central banks actively supporting this process. Eventually, however, there will become a time when the central banks become concerned about inflationary pressures which may arise if this process continues as we suspect.
In such an eventuality EM central banks may well have to hike rates in order to avoid inflation taking hold, while balancing that against their own required and targeted economic growth rates. Neither of these outcomes i.e. a weaker currency and thereafter, at best, the halting of depreciation via higher rates bear well for the underlying EM equity markets. We are by no means equity specialists here at Archbridge Capital but we can see how both scenarios, one after the other could take the gloss away from the once attractive EM equity markets and increase that of the USA.
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