As we've pointed out before, the historical behaviour of Emerging Market assets (stocks, bonds and currencies) can be understood by just a few common, primarily external, factors. Statistically speaking, changes in oil prices, bond yields, the dollar and Developed Market equities together explain most of the variation in Emerging Market asset returns. Accurately predict where this lot are going and you have a pretty good chance of getting Emerging Market assets right too. As with all things in capital markets (and forecasting in general), humility in the face of all the information that we simply cannot know from our current vantage point is appropriate. Nonetheless, after a week of important news flow affecting all of the above, we continue to see investors being rewarded for taking some risk in Emerging Markets. We explore why below.
Emerging Market assets seem to have been suffering from a little indigestion so far this year after the stellar returns of the last 2 years. Sharply higher US bond yields and a resurgent US dollar have certainly played their part in this, likely temporary, angst. Alongside this, while everyone loses out from a trade war, Emerging Markets would surely suffer the worst as the market reaction to jarring headlines and tweets on trade would suggest. Burgeoning global trade over the last several decades is the tide that has helped lift many of these economies, particularly Asia, to the happy state they find themselves in today. Any reversal, however temporary, will likely have a similarly disproportionate effect.
The absence of constitutional restraints on the US President in this area is important to remember for investors in Emerging markets. However, the approach of US midterm elections in November, with many now expecting the Republicans to lose the House of Representatives at the very least, may have some restraining influence. The more focused list of tariffs issued by the Chinese authorities (in almost immediate response to the US tariff list issued in early April) suggests that they are fully aware of this. Higher prices for soybeans would hurt the Chinese consumer as a key input into hog prices, a major part of China’s consumer basket. However, with 8 of the top 10 soybean producing US states coming out for Candidate Trump in the 2016 elections and 3 of these states in close run senate races in November, the bet is that the US side of the table will feel this war more keenly politically. Our suspicion remains that this ongoing trade skirmish will not deteriorate into a full blown trade war, with some form of negotiated settlement still by far the most likely outcome.
Another taper tantrum?
The ongoing pullback in Emerging Market assets amidst rising US yields, is reminiscent of the ‘Taper Tantrum’ of 2013. Back then, rising rate expectations caused investors to pull their money out of higher-yielding Emerging Market assets, as the potential returns on US assets increased. Today however, we think Emerging Markets are less vulnerable to a repeat of the Taper Tantrum. As a whole, Emerging Market economies have developed much more robust macroeconomic foundations relative to 2013. They have accumulated larger currency reserves to stabilize their currencies, kept their external indebtedness at reasonable levels, and reduced their reliance on external funding from foreign investors. Select EM economies which are dependent on foreign investment inflows, may face additional selling pressure should US yields continue rising. But as a whole, we think Emerging Markets are better placed to weather through rising US yields.
Oil and Iran
The US’ withdrawal from the increasingly infamous international deal to curtail Iran’s nuclear weapons programme certainly created media ripples, but from a markets perspective, it was widely anticipated. Indeed, oil prices actually traded slightly lower upon the announcement of the US’ withdrawal. However, for oil prices, the Iran story is certainly not the only game in town. A global economy finally moving out of the long shadow cast by the great financial crisis is providing a healthy demand story for oil. On the supply side, the removal of Venezuelan oil exports from the global market place is depriving the market of increasingly scarce ‘heavier’ crudes. The US onshore patch, for its part, tends to produce only ‘superlight’ crudes, for which the US refinery capacity is ill suited to utilize without blending with heavier grades. All this adds up to a market where, even without clipping Iranian output, supply is tightening and the prospects for demand remain healthy. From the perspective of our call on Emerging Markets, this should be net supportive of Emerging Market returns, whose universe consists of several oil-exporting economies.
Capital markets seem to be in a holding pattern at the moment. The debate on how late in a nearly 10-year old US economic cycle we are is unsettling some investors. It has certainly been a noisy start to the year for many economies. A long and difficult winter in Europe and a US administration moving on to the most business unfriendly parts of it agenda have perhaps helped to sharpen the ever jagged teeth of the business cycle. There is nothing too much sinister in all of this in our view. Above trend growth looks set to continue in many of the most important economies in the world while inflationary pressures remain sufficiently benign to keep central bankers normalizing monetary policy very gradually. Even in the US, where this process is furthest along, and most needed, we are looking at an interest rate rising cycle that is pedestrian by past standards. This backdrop should continue to allow the corporate sectors’ wares to shine. Emerging Market equities remain an important part of that.