It was bound to happen. Economists have been warning about it for years. U.S. equity and bond investors have been preparing themselves for it for a few months already. Now the rest of the world is bracing itself… the beginning of the unwinding of stimulus is nigh.
Though the U.S. Federal Reserve has not given the word yet, we all know it wants to end the monthly bond purchasing program, likely across the span of a year or so. Emerging markets are already experiencing withdrawal symptoms, with stock markets and currencies falling, and interest rates and inflation rising.
Yet some are expecting this to develop into a fine investment opportunity once the dust settles and everyone sees the U.S. Fed’s intentions more clearly.
From Stimulus High to Withdrawal
Many investors are likely already aware of the uplifting effects that three rounds of stimulus – which includes the current monthly bond purchases – have had on U.S. markets, with equities and bonds rising to record all-time highs.
Yet few are aware of how stimulus in the U.S. has also lifted emerging markets. Even though stimulus did not necessarily depress the American dollar, it did manage to inflate foreign currencies relative to the USD, creating a very lucrative currency trade in shorting the USD and longing foreign bonds.
Emerging markets thoroughly enjoyed the inflows, estimated at $4 trillion, pouring into their markets. Many developing nations have account deficits that depended on such foreign investment to keep their economies’ gears turning.
But since talk spread in May of the U.S. Fed’s plans to begin reducing its monthly bond purchases, those inflows of deposits into emerging markets have turned into outflows. Less bond purchasing by the U.S. Fed strengthens the USD and weakens other currencies against it. Fed bond tapering hasn’t even begun yet, but since May, the Indian rupee has already fallen 18% versus the USD, while the Brazilian real has fallen 20%.
Foreign equity markets have also tumbled recently, with China’s Shanghai index down 9% since May, India’s Sensex down 10%, Brazil’s Bovespa down 11%, the Philippines’ PSEI down 12%, and Indonesia’s JSX Composite down a staggering 22%.
Chris Weston, chief markets strategist at London-based IG Group, explains the plight of emerging markets to CNBC:
“Countries that have reasonable levels on inflation, run large current account deficits and continue to face worrying capital flow prospects are getting absolutely destroyed and remain vulnerable.”
Their money rapidly losing value leaves emerging markets with no choice but to raise interest rates to strengthen their currencies and prevent the withdrawal of all those sorely needed foreign deposits. Turkey has already had to raise its interest rate by 75 basis points in July and by another 50 this week to a stifling 7.75%.
But it’s not working, as Ishaq Siddiqi, market strategist at ETX Capital assessed to CNBC:
“Market participants do not want to get caught out on the wrong side if tapering does indeed start in September – that’s why we are seeing many in the market tinkering their portfolios to react favorably to tapering.”
Siddiqi preps us for more to come. “Expect this to be the theme until the Federal Reserve’s next meeting [in September],” he forewarns. “There is growing concern that capital outflows from emerging markets will rapidly accelerate.”
Some Flee, Some Stay
So where are all these deposits being withdrawn from emerging markets now headed? Siddiqi pin-points this, saying, “Investors would rather pile into growth-focused assets geared to the U.S. economic recovery.”
This not only includes U.S. equities but also bonds. The widening yields of U.S. Treasuries – with the 10-year rising to 2.9% this Monday and still well above 2.8% now – have been attracting some buyers already. These investors are expecting any bond tapering to be light and are thus betting on a bond rally back down to the low 2% area.
If, on the other hand, bond tapering turns out to be significant – highly doubtful, but always possible – investors would rather gamble on an American note that at most wouldn’t lose more than one additional percentage point than to risk a 4 or 5% further depreciation in foreign bonds.
Yet not all are fleeing high-tail out of emerging markets. Investment researchers EPFR Global out of Cambridge, Massachusetts revealed to Forbes that while retail investors “have nearly completed their exit from emerging” markets by having “reduced their bond holdings by about 25% from multi-year highs in May”, institutional investors “have not reduced their positions significantly”, given their generally longer investment timeframe.
Further evidence that not everyone is panicking out of emerging markets is seen in a rather calm U.S. Dollar Index (DXY), which has actually fallen 3.5 cents since May – not risen, as might normally be expected in circumstances such as this.
EPFR Global added, however, that institutions aren’t exactly buying emerging markets right now, and “may need to see a further drop in prices to buy.”
Join Wealth Daily today for FREE. We”ll keep you on top of all the hottest investment ideas before they hit Wall Street. Become a member today, and get our latest free report: “The Next Gold Rush: Three Easy Gold Investments fo 2020”
It contains full details on something incredibly important that”s unfolding and affecting how gold is classified as an investment..
After getting your report, you’ll begin receiving the Wealth Daily e-Letter, delivered to your inbox daily.
Differentiating Your Risks
What seems to be taking place, then, is a separating of investments according to risk. At the present time, any changes to U.S. Fed stimulus will have a greater impact on bonds than on equities, both in America and in emerging markets.
Barclays Capital analyst Koon Chow differentiates between the two markets to Forbes, noting that the selling is “arguably slightly less negative in equities than in fixed income where global institutional and retail positions are still large”. Chow suggests we might see “some asymmetry in emerging markets in the months ahead, with greater risks of disruptive moves in fixed income than in equities”, as Forbes paraphrases.
This would explain the surprising rebounds in some emerging market stock indices since June, such as China’s Shanghai index gaining over 2%, Brazil’s Bovespa index gaining 10%, and the Phillipine’s PSEI index gaining 14%.
Chow concludes that “technically speaking, emerging equity looks better than bonds given the considerably more advanced overall exit by both retail and institutional at this point.” This, though, does not necessarily refer to just the exiting that has already taken place, but to the ‘overall exit’ expected to continue in foreign bonds more so than in equities over the coming months.
Where to Go?
So if you have investments overseas, don’t throw your baby out with the bathwater. Prime emerging markets still have viable equity opportunities that will undoubtedly outperform even advanced economy equities once the global recovery finally gains some traction. The preference of equities over bonds is made ever more valid by just one simple measure: equities have unlimited upside potential; bonds don’t.
What is more, U.S. Federal Reserve bond purchases are on their way out, to be completely terminated by about mid-2014. Expect foreign currencies and bonds to continue sliding downward in value until then.
And what will come after that? Slow increases in U.S. interest rates until rate normalization by 2017-18, which will continue strengthening the USD and weakening foreign currencies and bonds.
The age of the bond is drawing to a close. The baton is just now in the process of being passed from an exhausted bond market to an equity market with legs – both in America and in emerging markets.
Joseph Cafariello
If you liked this article, you may also enjoy:
