Wall Street’s reaction to the October jobs report has been pretty clear. While last Friday led to mixed trading as the market took in the details, the start of this week has shown significant evidence of investors positioning themselves for a December Fed rate hike. US equities have sold off in an orderly manner, global markets are trending down, and treasury yields – which had spiked on Friday – have stayed above 2.3%. Alongside, the dollar has gained in strength, with the euro nearing 5-year lows again at $1.07. Importantly, Fed Fund futures indications of a December rate hike are showing a 70% probability. That’s pretty high, and the data point has been a pretty accurate one so far this year. While the Street remains polarized regarding the need or benefits of an interest rate increase, investors will nevertheless have to adapt – and emerging markets will be heavily scrutinized against safer assets. So, here’s what we’re thinking:
Caution Abroad: As the end of the 7-year long unconventional US monetary policy comes closer, the repricing of assets has already led to significant volatility and divergence between developed and emerging market classes YTD. The Fed rate hike – whenever it occurs – will potentially enhance capital outflows from the regions, where investors have sought returns in a low yield global environment – essentially all the way back since the early 2000s. Emerging markets greatly benefited with capital inflows after the Fed lowered rates in the aftermath of the dot-com bubble to stimulate the US economy; the BRICS led the world’s corresponding growth, and provided a cumulative stock market return of over 420% from 2001 to 2010, compared to a 44% gain for the MSCI All-World Index and approximately 15% for the S&P 500. Post-2008, the economic environment changed, but monetary policy remained accommodative. 2013, however, was a turning point – where the signaling of the end of Fed quantitative easing led to the infamous ‘taper tantrum’, hurting emerging market stocks and bonds all around. The emerging markets index (EEM) has returned approximately –15% since then to date, compared to the S&P 500’s return of nearly 30%. Net capital outflows this year have amounted to $540 billion, per the WSJ – the largest amount since 1988. Volatility, meanwhile, has been elevated, and we’re thinking the underperformance will continue until after the rate hike occurs.
Alongside, China’s economic landing remains a source of concern. With an $11.4 trillion dollar economy, the country was a leader in commodity consumption over the past decade, consuming over half of the world’s iron ore, coal, aluminum, and nickel, leading to the well-established commodity super cycle and benefiting markets including Brazil, Malaysia, and others. The super cycle began in 2000, and peaked in 2008; the Bloomberg commodities index is down 61% since then given slower global growth, the reorientation of economic drivers, and unconventional monetary policies worldwide that have led to currency moves, which, in turn, have pressured commodities that are denominated by them, including oil, for example. As a result, the 44 nations that consider China their largest market have also suffered, and US monetary tightening will likely only add to the complexity. As we’ve mentioned in our previous columns, emerging market debt has quadrupled since 2003, with bonds outstanding at $18 trillion today, while foreign ownership has also increased substantially. Emerging market debt denominated in foreign currencies has doubled over the past 5 years, to over $1.4 trillion. Overall, the EMD sector has delivered an annualized 7.8% return over the past 15 years – the best performer in the fixed income asset class. The data shows that investors have gone searching for yield with the expectation of low yields in the US. The 2013 taper tantrum was a wake-up call, and consequently, a future rate hike should, in principle, be navigated with caution around emerging market investments.
What it means for you: Emerging market investors should brace for some rough seas ahead in the short term. Furthermore, some divergence with the sector among nations is likely. Those with commodity-driven exports, foreign exchange reserve deficiencies, and high government spending remain the most vulnerable, while the implementation of domestic reforms, government elections, and state owned enterprise divestment signals may provide upside surprises. Morgan Stanley’s Troubled 10 list provides some names, and will be in the spotlight as the year-end comes closer. At the same time, note that 80% of the world’s population resides in emerging markets. To quote Todd McClone in a recent Barron’s article, ‘if we can’t find companies that are benefiting from the spending habits of the 5.8 billion people living in developing countries, then I don’t know what we are doing here’. If emerging markets live up to their name and ‘emerge’ in the long run, the short term roller coaster rides will be well worth it for investors that choose to stay the course.
