Emerging markets receiving the oxygen for recovery
James Barrineau argues that the key factors remain in place for emerging markets to maintain their current strong momentum.
Unstructured Learning Time
Emerging markets (EMs) are running at full throttle:
- The local currency index, after a historically unprecedented fall, is up 9% this year.
- Dollar sovereign debt is up 4.5% – about four times the return for the whole of 2015.
- Interest rate spreads over US Treasury bonds have fallen 100 basis points since the highs of 11 February.
Why did this happen? And can it go on?
Our three investment theses for EMs - Chinese currency stability, oil stability, and supportive developed market central bank policy - have now been in place since late January.
The stabilising factors for the asset class actually began to fall into place before being reflected in asset prices. But, as we have often stated before, the single most important factor for EMs is the trend in the dollar.
Following last week’s meeting of the US Federal Reserve (Fed), and its message that rates are likely to be significantly lower than expected this year, the level of the dollar against the basket of currencies represented by the DXY Index fell to its lowest since last October.
But much more important is the trend and its underlying driver. The divergence in developed market monetary policy that had been propelling the currency higher is effectively over, given the Fed’s new dovish stance.
That will be an ongoing support for EMs – after all, the dollar’s stratospheric rise from mid-2014 was jump-started by a Fed promise to raise interest rates at a time when other central banks were running in the opposite direction.
Along with continued gains in the oil price, we need no further reassurance that the positive background continues.
Breathing life into EM assets
What follows from these supportive factors is the oxygen for the EM recovery – liquidity into the asset class.
- Measured from one perspective – the rate of change of global foreign exchange reserves – liquidity has risen sharply.
- Measured from another perspective – the ability to issue debt – liquidity has picked up after sovereign issuance jumped sharply in the last six weeks following a historically slow start to the year.
- Measured from a third perspective – fund flows – liquidity has also turned sharply positive.
Our risk appetite in this asset class is predicated on a simple, intuitive, historically reliable fact: when the rate of liquidity flowing into the asset class rises, asset prices follow upwards.
Though we cannot predict the future, it is historically unlikely that the rally would stop in its tracks without a sign that those flows are waning, even if their rate of growth may slow.
Discounting the negatives
The counter-argument to this seemingly optimistic scenario is that fundamentals remain shaky: companies have increased their debt levels and now have limited access to the market, while economic growth may be slow to return.
All of those points are hard to argue with. However, liquidity has always preceded fundamentals, whether up or down. So further improvement in EMs as currencies rally and central banks either stop hiking or cut interest rates is a high probability.
The last point that is continually impressed upon us as we talk to potential and current investors is the unrealistic view that still prevails about EMs.
- Investors bemoaning EM growth of 3.5[(-4) was not found] – down from the 6% or more seen in the past – are yearning for a world that may never return, at least in the short term, given that developed markets now do well to produce 1.5% growth.
- By the same token, those waiting for EM dollar debt to yield 9[(-10) was not found] before buying are ignoring a world where 24% or so of the global government bond index trades at negative interest rates in a yield-starved world.
- And investors worried that debt issuers will now rush in to dampen the rally are forgetting that sovereign issuance was set to be close to negative on a net basis this year.
- Moreover, the European Central Bank’s new policy stance is incentivising the issue of euro-denominated debt that should inject an additional positive technical factor into the market.
Taking all these things together, the world we have before us seems to suggest there still seems to be good value in EM assets.