“This Was Inevitable At Some Point”: Is There A Storm Coming For Emerging Markets?

Remember August, 2015?

No? That’s ok, I barely do either. What with all the conspicuous, brain-cell-killing, fine spirits consumption between then and now.

But what I do remember is that the Fed had a tough call to make the following month. China’s “surprise” move to devalue the yuan threw markets into turmoil and the committee was concerned that anything other than a conciliatory dovish lean (that is, “a clean relent”) had the potential to exacerbate what looked like the beginning of a global unwind by putting upward pressure on the dollar and catalyzing EM turmoil

Well fast forward to today and EM assets have shaken off talk of a Fed rate hike cycle. Indeed, Q1 was a good quarter for emerging markets. As Goldman wrote last week, “EM outperformed DM on a cross-asset basis, with MSCI EM up c.5% more than MSCI World, EM credit outperforming DM HY credit by c.1.5%, and EM FX up 3.6% against the dollar.”

So the question after Wednesday’s Fed minutes is this: is EM truly prepared for what’s coming or did we get a false sense of security during the first quarter thanks in no small part to three months of USD weakness?

Below, find some commentary from analysts on this very subject collected and summarized by Bloomberg.

Via Bloomberg

Emerging-market bonds, stocks and currencies will probably retreat as the Federal Reserve starts shrinking its super-sized balance sheet this year, investors and analysts say. South Korea’s won had the biggest drop among Asian currencies on Thursday, while 10-year bond yields rose in Malaysia and China. Minutes of the Fed’s March meeting released Wednesday said the reductions need to be “gradual and predictable.” Its balance sheet ballooned to $4.5 trillion after three rounds of bond purchases.

Market Views:

• Schroder Investment Management (Rajeev De Mello, head of Asian fixed income)
  • The Fed’s minutes confirmed views that the tapering of the balance sheet will be starting sooner than earlier expected
    • The U.S. yield curve could steepen further which would also impact local yield curves, especially those in the more developed part of Asia. Hong Kong, South Korea and Taiwan should also see some steepening
    • “We don’t believe that this announcement by itself would lead to a period of market turmoil. Investor interest in emerging markets has been strong as we would expect it to continue”
  • Other concerns include the uncertainty around the timing and size of U.S. fiscal policy expansion and the uncertainty around the French elections

• Daiwa SB Investments (Shinji Kunibe, general manager and head of fixed-income management)
  • The shrinking of the Fed balance sheet would hurt U.S. stock performances and slow momentum for the U.S., which would then worsen sentiment for emerging markets as they have benefited from global recovery led by the U.S.
    • Emerging Asia may be hit slightly less than Latin America and EMEA as countries like India remains strong
    • Political stability and good fundamentals make India look more attractive than other emerging economies; Indonesia also looks pretty good

• BNP Paribas Investment Partners (Hue Lu, senior investment specialist)
  • “This was inevitable at some point. Removing market- supportive measures is a good indication that the recovery in the U.S. is on track”
  • As for EM implications, some economies will obviously face more headwinds than others depending on how much dollar debt is on their balance sheet
    • “For Asia, we are not that concerned, and we think the market generally agrees. Following the recent December rate hike, investors barely blinked”
    • Equity investors have generally already priced in another two, 25bp hikes this year. The bond market is more skeptical that we would even see tightening at this pace
    • Those economies viewed as “fragile” within Asia are in a better situation today as a result of reforms which have been implemented in recent years —- and this is particularly true for Indonesia and India

• ABN Amro Bank (Roy Teo, senior currency strategist)
  • The impact may not be as large as it will be gradual and well-communicated
    • The market is pricing in slower rate hikes as a result of balance-sheet normalization. EM Asia fundamentals and FX reserves have also improved

• Standard Chartered Bank (Divya Devesh, Asia foreign-exchange strategist)
• Fed balance sheet normalization will likely put upward pressure on long-term yields in the U.S., which will be negative for EM Asian currencies.
  • The impact will also depend on whether the balance sheet normalization is happening in conjunction with hikes in Fed Funds rate.