Do Emerging Markets Have You Sea-Sick?

June 3, 2016Emerging Marketsby Dan Steinbock

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Where is the logic in the Emerging Markets rapid reversals?

In the past year, investors have seen emerging markets thrive, plunge, re-emerge and re-decline. Despite the volatile short-term story, the fundamentals of the emerging market assets remain strong.

Last fall, the Wall Street Journal reported that rich nations were “losing emerging markets motor.” Reportedly, the woes of developing economies were ricocheting back to advanced ones and hurting their fragile recovery.

By spring, many investors were exploiting a sweet spot for emerging market assets. That’s when Stanley Druckenmiller, former partner of investor guru George Soros, saw big opportunities in emerging markets. Today, the tone appears to be changing again as market observers report, “the emerging market dream story may be over.”

What’s going on? Is there a logic to these rapid reversals of Investor sentiments?

Fed and emerging markets

Emerging markets' fundamentals remains intact. Since the early 2000s, the relative share of the emerging economies has steadily increased in the world economy.

In 2010, the US, Europe and Japan still accounted for almost three-fourths of the world economy, China, India and rest of Asia, barely a fourth. By 2030, the share of the advanced economies may shrink to less than one-third of the world economy, whereas that of emerging economies may account for almost a half of the total.

While the trend line is clear, evolution won't be smooth sailing. In the early 2010s, as long as the U.S. Fed kept rates in the zero-bound and engaged in quantitative easing, China and other emerging markets coped with currency appreciation, inflation and asset bubbles. When the Fed ended QE and began to prepare for hikes, the “hot money” inflows morphed into outflows. In emerging markets, that translated to appreciation, deflation and asset shrinkages.

In markets, the Fed's expected rate hikes herald a perceived demise of the emerging market assets. Some three years ago, when Ben Bernanke flirted with the idea of an exit from quantitative easing and future rate hikes, that alone caused a major “taper tantrum” as US dollar strengthened, and emerging markets took a hit. In 2014-15, the Fed's expected rate hikes were preceded by months of rising dollar, which caused emerging-market currencies to decrease accordingly.

As long as investors expected the Fed to hike the rates – even if the latter would remain fever and rate increases lower – the value of the dollar continued to climb. In addition, since we still live in the end of the ‘petro-dollar era’ when commodities are denominated in US dollars, oil and gas prices plunged.

The long-term story

However, the “advanced markets are back” story is untenable. It ignores advanced economies' slow, inadequate deleveraging, which constrains their economic prospects. It neglects their secular stagnation – ultra-low growth, minimal inflation –, which will deepen in the medium-term, thanks to greying populations and anti-immigration attitudes.

Until late 2015, three headwinds were still driving the advanced markets story: the rising US dollar, plunging commodity prices and China’s deceleration. In the past few months, those headwinds have fueled emerging markets, due to the stagnating US dollar, strengthening commodity prices and Chinese growth, which remains three-four times as fast as growth in advanced markets.

Today advanced economies still dominate the markets, due to their historical dominance (and the legacy of colonialism). However, what makes markets volatile is the fact that secular stagnation will prevail in advanced economies. That’s why rate hikes have proven so challenging to the Fed, which has not been eager to reduce its balance sheet. That's also why Europe and Japan will keep rates low and continue QE for years to come.

Nevertheless, whenever the Fed will signal eagerness to hike rates, the dollar will temporarily strengthen and emerging markets will take hits.

What’s the lesson to investors? In the short-term, opportunism will prevail, especially in anticipation of the Fed’s rate hikes. In the long-term, fundamentals will rule the markets. In addition, that bodes well to emerging markets.

Emerging markets will be volatile in short-term, strong in long-term is republished with permission from The Difference Group