Let’s talk about emerging markets.
Over the past five days, it’s become abundantly clear that the Fed was getting a bit nervous about the odds the market was assigning to a June rate hike. In short, it was readily apparent that virtually everyone assumed next month was a no go. The looming Brexit referendum only added to investors’ dovish convictions (surely the Fed wouldn’t dare hike right into a potential tail event).
And as I noted on Thursday, the market might have been getting a bit worried as well. Here’s how I put it:
“It wasn't so much that anyone was anxious to see the Fed pull the punchbowl back by another 25 bps. And it certainly wasn't that anyone was complaining about higher stock prices. Rather, it was beginning to feel like the FOMC might never be able to normalize policy - literally.”
That’s a scary thought. A perpetually dovish Fed puts Japan and Europe up against the eight ball in terms of boosting domestic inflation and growth and it also suggests that if and when the next downturn comes for the US economy, the Fed will be powerless on the rates front.
Suddenly, everyone is a hawk and the April Minutes betray a bias towards June - Brexit or no Brexit. The “Shanghai Accord” it would appear, is no more. The problem, of course, is that this sets the stage for a bloodbath in emerging markets. On Thursday, I commented at length on a Bloomberg piece that describes the return of a binary risk-on/risk-off market dynamic. “Rather than being led by economic data or monetary policy, emerging-market exchange rates are the most closely tied to moves in stocks and commodities since at least 2013,” Bloomberg wrote.
This is a risky proposition. As we saw last autumn and also in January, trouble in EM (especially China) and falling oil prices can have a profound effect on risk appetite and can quickly ricochet back into advanced economies playing havoc with DM equities.
The Fed then, is gambling. Importantly, it’s the exact opposite of the gamble the Committee made last September. Then, they were betting that supporting EM at a time when capital was fleeing China at an unprecedented pace was more important than sending a positive signal about the health of the US economy. Now, the FOMC is betting that it’s more important to reinforce the idea that the data in the US is strong enough to warrant a second hike than it is to safeguard EM.
Whether or not that’s a wise move in terms of the potential for a boomerang effect on DM risk assets (i.e. stocks) depends on how interconnected you believe markets have become. But if you’ve been fortunate enough to ride the EM FX/equity wave off the February lows you may want to consider taking profits ahead of the Fed.
Along those lines, Goldman is out on Friday with a note that takes a look at the correlation between EM FX and equities. The message is clear: “Going forward, we expect meaningful MSCI EM correction during 2Q through both equity and FX components.” Here are some key excerpts:
“The EM rally this year in both equities and FX had been ‘fast and furious’ – MSCI EM rose by a significant 24% in USD returns while EM FX appreciated by 8%. Since April 21, however, the rallies in both asset classes have started to fade.”
“Since the start of 2015, EM equity (in local currency terms) and EM FX (market cap. weighted) have moved closely together. Even though EM equities and FX do not necessarily embed similar signals – equities are more growth driven while FX tend to be more current account and macro rebalancing driven – they have historically been tightly correlated.”
“In the most recent rally, we saw MSCI EM rise by a significant 24% in Dollar returns before hitting the peak on April 21. Out of the 24% return, 16% can be attributed to the EM equity rally, while the remaining 8% is derived from the large FX appreciation.”
“Hence, the recent MSCI EM rally is relatively more ‘FX heavy’, suggesting that supportive currency valuations and broad-based improvement in EM current accounts, along with favorable macro tailwinds, have propelled the strong performance.”
In other words, in the current environment, a soaring USD as a result of a hawkish Fed may have an even more deleterious effect on EM than usual.
The takeaway: if you take the Fed at its word on this week’s hawkish lean, it’s look out below for EM. Or, as Goldman concludes: “Given the recent softness in China activity data and relatively hawkish April FOMC minutes, the positive macro backdrop may fade even as the oil price stabilizes [and] therefore EM equity and FX could face a more challenging, choppier period going forward.”
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