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Yet another re-emergence is under way. Last year's US election thwarted what had been a promising recovery for emerging market equities, after a long and disheartening bear market. This shows how emerging markets performed compared to developed markets from the beginning of last year.
One of the most dramatic responses to the Trump victory was to send money pouring back out of the emerging world and into the US. A pro-growth US president should normally be good for emerging markets, but flows of money matter more than anything else, and they were directed towards the US.
An attendant problem was the stronger dollar that followed the election. That led to worries about emerging market currencies, and the risk of crises in Mexico (very much related to the advent of Trump) and Turkey drove another decline. But now EM is on the way back. The critical difference this time is probably that the dollar is weaker, in part thanks to jawboning from the US administration:
Also note that this is not just about Mr Trump. China and its insatiable appetite for raw materials from the rest of the emerging world has long been the key driver of emerging markets. And it remains so. The price of industrial metals suggests a China that is spending again, and helping exporting nations, particularly in Latin America:
The performance of China-exposed stocks, as I have said before, shows continuing strength emanating from China:
If we look at the varied performance of the different emerging geographical sectors, the interaction of the US and China is clear:
Latin America, the most China-exposed sector, suffered the biggest falls during the bear market, and has enjoyed the biggest rebound — up some 60 per cent from the nadir. But look at the effect that Mr Trump’s attitude towards Mexico had on LatAm after the election. Mexican assets have recovered a bit in recent weeks, but it would plainly be unwise to assume that the worst is over.
The final driving factor behind emerging markets is, as ever, fund flows. Joe Rennison and Eric Platt report that:
Emerging market equity funds attracted the most money from investors in six months, as resilience in commodity prices and signs of improvement across the world’s major economies sharpened investors’ appetite. The EM funds secured $2.7bn this week, with exchange traded funds pulling in $1.8bn of the total, according to data from EPFR. Interest in EM equities was mirrored by bond investors, who handed EM debt funds $1.3bn.
That will help. There are sincere believers in the reflation trade out there. Providing the reflation trade comes through as hoped, then emerging markets should perform very well. The best reason to expect this, as ever, is valuation. These numbers from Research Affiliates’ invaluable asset allocation website show that, using Robert Shiller’s cyclically adjusted price/earnings multiples, emerging markets look unambiguously cheap compared to their history. The same is not true of the US:
Exchange-traded flows
On the subject of emerging market flows, note that they virtually all come from ETFs. This spectacular chart from a guest piece in the FT by Terry Smith, the founder of Fundsmith:
He argues that this is unhealthy, and he is completely correct. Indices tend to be weighted by market cap, which means they invest most in the biggest companies in each country. These often tend to be poorly managed poor state monopolies. The more exciting opportunities in emerging markets require much more careful searching in public markets, or even private equity.
Awaiting the Fed
One more reason why the chances that Janet Yellen goes through with raising rates next month have been underestimated; the Fed’s favoured measure of inflation is in a clear upward trend. This chart is from Mickey Levy of Berenberg:
With the Fed Funds rate now deeply negative — meaning that the recent rise in inflation has rendered current policy more accommodative — he suggests that the chances of a March hike are now above 50 per cent. This is notably above the odds that the market is putting on this. As far as Mr Levy is concerned, it is Ms Yellen's “devoutly doveish nature” which is holding the Fed back.
That might be a tad harsh. She certainly sounded like a hawk this week before Congress, but he offers a good laundry list of reasons why the Fed should be raising sooner rather than later:
- On the inflation front, the consumer price index (CPI) accelerated in January by a strong 0.6% mom — 0.3% excluding food and energy — and these increases will be reflected in January’s personal consumption (PCE) deflator that we estimate will rise close to 2% yoy.
- Leading up to the March FOMC meeting, in addition to anticipated further signs of economic improvement and inflation approaching the Fed’s target, expect the February employment report (released on 10 March) to reveal a healthy rise in wages, further confirming tighter labour markets.
- A growing number of Fed members seem to be growing uncomfortable with Yellen’s dovish, gradual rate increase strategy, and have confirmed three likely rate increases in 2017. Joining the traditional hard money members in arguing that the Fed must not delay interest rate normalisation is Federal Reserve Bank of Boston President Eric Rosengren, who has expressed concerns about commercial real estate. Middle-of-the-roaders like John Williams of the San Francisco Fed acknowledges rate hikes should proceed.
I certainly agree with him that the chances of a March rate rise are now above 50 per cent. It would take a disappointing unemployment report next month to change that.
Bond tantrums past
Bond yields have risen very sharply after posting a historic low last summer. But we should not be too fast to assume that this is, at last, the end of the great bull market in bonds that started more than three decades ago when Paul Volcker was running the Fed.
This chart from the Bank of England’s Bank Underground blog compares the latest alarum in the bond market — which has subsided, at least for now — with some other incidents over the last quarter century or so. It looks just like all the others, from the bond bear market that Alan Greenspan triggered in 1994, through to the sell-off in gilts that followed Theresa May’s speech last year in which she set out a “hard Brexit”.
The most important point is that after all these previous bond sell-offs, the ongoing bull market in bonds continued. It is too soon to say the bond bull market is over. If the Trump administration can deliver anything close to what the stock market now appears to expect, however, an end to the bond bull market is likely.
