When will emerging markets begin to rally?

“As much as I would like to buck the bearish sentiment, I continue to see EM as an underweight, in currencies, bonds and equities.”

That’s how I ended the last post.

Yet, at the same time, even as crisis deepens in the emerging markets, my eye is on the buy signal because of the relative value.

The strong dollar as precipitating force

Before I get into when to buy, let me go back to why we even have a crisis. And it’s clearly policy divergence and the strong dollar. We first got a whiff of this in 2013 during the taper tantrum, when markets reacted violently to the unexpected announcement that the US would wind down its quantitative easing program.

At the time, Morgan Stanley coined the term “fragile five” to refer to five emerging markets that were the most vulnerable to outflows of foreign capital because their current account deficits made them dependent on foreign capital. We’re talking about Brazil, India, Indonesia, Turkey, and South Africa.

But at some point investor sentiment toward the EM space began to improve and the potential crisis faded from view. But once the regime shift toward a more aggressive rate hiking campaign began with the Chairmanship of Jerome Powell at the Fed, another EM selloff began. And again, we had a crisis.

In both cases, Fed policy and a strong US dollar were a precipitating force. But I don’t know if you could call them the underlying factor. Take a look at the US Dollar Index chart.

US dollar index.png

When the dollar was gaining the most in 2014, EM was actually recovering. And in 2018, as the dollar has shot up, it has done so to a lower level than in early 2017 and at a rate no greater than throughout 2016.

In short, the currency side isn’t the end all and be all of the EM crisis.

The current situation is getting worse because of liquidity

This morning, the MSCI Emerging Market Index extended losses to a seventh consecutive session, with the index now in bear market territory. And I think this downdraft originates from two places. One is liquidity, with hot money flows causing people to sell. The second is the real economy, now coming under pressure due to worsening currency and interest rate environments.

Yesterday, I mentioned two examples on the real economy side of things, with the Philippines experiencing inflation and South Africa staring at a recession. But I think it’s the money flows that are most important here because they are what create contagion and crisis. The liquidity problems lead and the real economy problems follow.

Now, modern orthodoxy in economics and finance says that free capital flows are good. Yet, on numerous occasions over the past two decades since the Asian Crisis we have seen examples of crises significantly worsened by the withdrawal of global liquidity.

After the Asian Crisis, Asian countries decided to focus on building foreign exchange reserves rather than on restricting capital flows as the best way to forestall a crisis. And I believe we are going to see this solution tested before the EM crisis is over. And that’s because the selloff in foreign exchange markets has set off a chain reaction.

  • First, emerging market currencies declined. And at some point the decline in the currencies was large enough to precipitate an outflow of investment in bond and equity markets.
  • Alarmed by the fall in all three – currency bonds and equities – and at the rise in imported inflation from the fall in currency values. EM central banks began raising interest rates.
  • As a result, the real economy started to slow. And EM bonds and equities took a hit due both to the interest rates and the slowing economy.

So, this is all about the receding global liquidity, people pulling their money out of the emerging markets. When that outflow stops, the pain will stop.

What influences liquidity flows?

Some people would say macro fundamentals are the key. That’s why the Fragile Five were called out during the Taper Tantrum. And that’s also why Turkey and Argentina were the first to succumb this go round. But fundamentals can’t completely insulate a country from contagion risk. Investor sentiment driving liquidity flows is simply too important.

For example, data from the Institute of International Finance (IIF) that tracks capital flows into more than 50 emerging markets shows that, after China devalued its currency in 2015, other emerging markets had a sharp rebound in inbound hot money flows. The tide of foreign inflows was the strongest since the taper tantrum. That’s investor positioning at work.

And what’s more, the IIF effectively found that this massive inflow of hot money post-China devaluation meant that EM is now more at risk to a reversal of capital flows. Hence the crisis at hand.

Is the US peaking? Then buy EM

I think the US policy divergence scare is nearly over. And depending upon how this plays out, that’s positive for EM.

If the US economy continues to show strong numbers but is joined by other major central banks like the ECB, the Bank of Japan, Bank of Canada and the Swiss National Bank in raising rates, that means another leg down for EM and a worsening crisis.

On the other hand, if the US economy cools off, then the pace of expected rate hikes will likely fall. And the emerging markets would be off the hook. I think we will have an answer in the next month or two.

In a best case scenario, that means buying the emerging markets very soon.

Over the longer-term, emerging markets are going to have to do something about the tide of hot money.  EM businesses have built up an unhealthy stock of foreign currency debt that makes their economies vulnerable to the shifting sentiment of investors. And while the EM complex may escape this particular crisis, eventually it will be caught out. And a withdrawal of global liquidity will almost certainly be the reason why.

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