A More Demanding Powell Put to Test EM’s Strengthened Mettle
The Fed chairman makes clear the bar for slowing monetary tightening is higher nowadays, and argues emerging markets are much better positioned to handle higher U.S. yields than they were before.
After two stellar calendar years, emerging market stocks appear to be falling back to earth in 2018. Fears that rising U.S. interest rates will draw money out of developing countries and back into the U.S. may be buffeting emerging market assets, though the concerns may also be overblown, if not misplaced.
Nonetheless, emerging market investors should buckle up, as the cross-currents from souring market sentiment amid improving fundamentals within the asset class will likely cause near-term turbulence. As the EM price action seems to show, investors are starting to flee with the rise in U.S. rates, and perhaps plan on returning to emerging markets when the U.S. monetary cycle turns. But those who hold on with a dedicated allocation to EM have plenty of reason to think that longer-term they will come out of the bumpy ride ahead much better off.
The reasons were outlined in an important and rather hawkish speech by none other than U.S. Federal Reserve Chairman Jerome Powell, who on May 8 in Zurich argued that monetary stimulus by the Fed and other major central banks “played a relatively limited role in the surge in capital flows to emerging market economies in recent years.” He pointed out capital flows to emerging markets “were already very strong before the Global Financial Crisis, when the Federal funds rate was comparatively high.”
Conversely, flows to emerging markets eased after 2011, when the Fed “continued to add accommodation and reduce yields through increases in its balance sheet,” Powell said. “And more recently, capital flows to emerging market economies have picked up again, despite the fact that the Fed has been removing accommodation since 2015.”
To be sure, net flows into emerging market long-only equity funds and ETFs hit $54.88 billion from the beginning of this year to May 2, according to Bank of America Merrill Lynch’s May 3 Flow Show report. But they appear to be peaking, and net outflows from emerging debt funds began in mid-April for the first time since December of 2016.
This shouldn’t be too surprising given the historical knee-jerk reaction of investors scrambling from emerging assets when U.S. yields jump. It was most clearly on display during the “Taper Tantrum,” when five years ago this month, then-Fed chairman Ben Bernanke said the monetary authority would start reducing its “quantitative easing” asset purchases. Over the following month, U.S. 10-year Treasury yields jumped 22%, while emerging market equities fell about 16% and even U.S. high yield bonds dropped nearly 7%.
So far this year, the 10-year yield U.S. Treasury yield has climbed some 60 basis points to around 3%, prompting overseas borrowers with dollar-based liabilities to start deleveraging. Meanwhile, U.S. investment-grade and high-yield corporate bond issuance has dropped 12% and 25%, respectively, over the four months through April. And the U.S. Dollar Index, which averages the dollar exchange rate to a basket of major currencies, climbed to 93 on May 10 from nearly 89 in February.
Powell signaled that the Fed won’t be deterred. “More broadly, it is notable that although the Fed has raised its target interest rate six times since December 2015 and has begun to shrink its balance sheet, overall U.S. domestic financial conditions have gotten looser, in part due to improving global conditions and central bank policy abroad.” We recently noted this dynamic in a post on the untethered fears of a potential yield curve inversion.
The Fed chairman continued: “There is good reason to think that the normalization of monetary policies in advanced economies should continue to prove manageable for emerging market economies. Fed policy normalization has proceeded without disruption to financial markets, and market participants’ expectations for policy seem reasonably well aligned with policymakers’ expectations in the Summary of Economic Projections (the black dots), suggesting that markets should not be surprised by our actions if the economy evolves in line with expectations.”
Thornburg Fixed Income Portfolio Manager Jeff Klingelhofer says the Fed appears willing to look through market dislocations. “We should expect the bar to be pretty high for this Fed to bow to market pressure.” Probably more than the Greenspan put, the Bernanke put or the Yellen put—market concepts that played off put options to imply that monetary policy would create a floor under contracting equity markets—the Powell put seems to be further out of the money, Klingelhofer says.
With U.S. inflation gauges effectively at or above the Fed’s targeted levels, wage growth running at an annual pace of 2.6% to 3.3%, depending on the measure, and first-quarter economic growth clocking in at 2.9%, there’s certainly more tightening to come. Hence higher yields alongside healthy economic growth amid continuing “normalization” in monetary policy should “prove manageable” for both the U.S. economy and emerging markets, which are generally in far better economic shape now than they were during the Taper Tantrum, not to speak of their vulnerabilities during the 1980s and 1990s.
Indeed, as Powell also noted, many emerging markets have “substantially improved” their monetary and fiscal policies, and adopted more flexible exchange rates, “a policy that recent research shows provides better insulation from external financial shocks.” Moreover, EM corporate debt at risk, defined as debt from companies with limited debt service capacity, has been “relatively limited outside of China and has begun to reverse as stronger global growth has pushed up earnings,” Powell added. Even such debt in China has been receding, from nearly 70% of its gross domestic product a few years ago to just more than 50% today.
Ben Kirby, another Thornburg portfolio manager who helps pilot global and emerging market equity investments, says that heading into the Taper Tantrum, the problem children were Brazil, India, Indonesia, Mexico, South Africa, and Turkey, which together had a roughly 4% current account gap. “It was a big problem. When flows reversed, they had to pay more to keep their economies going,” he says.
But today, their current account deficits stand at a combined 2.3%. And the picture is even better among all emerging and frontier markets, which this year should sport a current account deficit of just 0.1%, according to International Monetary Fund forecasts. That effectively means that if the EM equity’s correlation to the U.S. 10-year Treasury yield is fairly high, the magnitude of the impact no longer is, Kirby adds.
Part of the reason for that is the significant change in the composition of the MSCI EM Index, he adds. A decade ago, energy and materials together accounted for about 30% of the index, while technology was just less than 15%. Today, energy and materials represent 14.5% of the index and technology comprises 28% . “And tech isn’t that sensitive to rates,” Kirby says. “EM is less rate sensitive from a fundamental standpoint than it used to be.”
To be sure, as commodities are effectively priced in dollars, developing countries that are net oil exporters will benefit from this year’s jump in crude prices, while the importers will suffer. And those EM central banks that hoped to ease policy will likely have to pause or reverse course, as the stronger dollar undercuts local currencies and can stoke imported inflation.
But investors should keep in mind that the IMF still expects emerging market economic growth of 4.9% this year and 5.1% in 2019. Meanwhile, Kirby notes that consensus forward MSCI EM earnings growth is running around 21% this year, and estimates are going up. While that’s only a hair more than the 20% growth in the developed market consensus outlook on the MSCI World Index, MSCI EM is trading at a 25% discount to the MSCI World Index on a price-to-forward earnings basis.
So emerging markets are on better economic footing today, with strong earnings growth and relative valuation advantages over developed markets. Perhaps those investors who benefitted from EM equity returns of nearly 50% over a combined 2016 and 2017 think EM will be harder pressed to post more gains. But as Thornburg Portfolio Manager Charles Wilson has pointed out, the stellar returns in the two-year period were largely driven by energy and materials. So far this year, while energy continues to be a major contributor, a wider cross-section of sectors is driving performance.
And while forward earnings expectations didn’t really accelerate in the first third of 2016, the forward MSCI EM Index P/E rose 6.3% in the period. This time around, forward earnings climbed nearly 5% over the first four months of 2018, while the forward P/E contracted by almost the same amount. EM returns may yet be far from peaking.