EM investors can take only small comfort from Fed

The Federal Reserve has done it again. The US central bank’s abandonment this week of an earlier projection that it would raise rates twice more this year has left investors “inspired by the knowledge that cheap money is here to stay”, said Jasper Lawler, head of research at London Capital Group.

Yet the comfort that fund managers can take from believing that the Fed has their back may not be what it once was. For emerging market investors in particular, the prospect of a Fed more minded to cut rates, with the consequent pressure on the US dollar, is not unalloyed good news.

“The incremental bounce that you get from dovish surprises is becoming less and less,” said Robin Brooks, chief economist at the Institute of International Finance, an industry association and EM data gatherer.

Not only are such dovish surprises from the Fed carrying less weight, they are also likely to be less frequent. Luis Costa at Citi argues that this week’s surprise was one of the last significant Fed-induced shocks that investors can expect this year.

“It is difficult to imagine another sizeable help to EM assets,” he noted, “given that the markets already have a very good idea of the ultimate size of the [Fed’s] balance sheet”, which the central bank said it will stop shrinking in September. If the Fed does pull another surprise, he said, it may be because of a deteriorating outlook for US growth, which will be more harmful for risky assets.

You only need to look at last year for a reminder of the influence the Fed can wield over emerging markets. The year started with a rally, helped by a strong consensus among investors that the US dollar would weaken. When that proved misplaced, EM assets suffered their deepest sell-off since the taper tantrum of 2013 — itself triggered by the Fed’s announcement that it would begin cutting its bond-buying programme.

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When dollar strength then peaked in the fourth quarter of last year, EM assets rallied. Investors began 2019 in better spirits, and January’s sharp rally reflected confidence that the Fed would hold off from raising rates, as trade tensions between the US and China appeared to recede.

Yet that buoyant start to the year has run out of steam. Mr Brooks at the IIF believes the explanation lies in how investors were already positioned in EM assets. He and his colleagues analysed balance of payments data from 25 emerging economies to find changes in each country’s international investment position (IIP) in portfolio assets — or the value of stocks and bonds held by foreign investors.

Between 2010 and 2018, which included years of very heavy quantitative easing, there were few surprises: both flows and, less consistently, valuations contributed to a huge build-up by foreigners of holdings of the stocks and bonds of EMs. Last year, these IIPs fell, but it was almost all a result of falling prices rather than investors pulling out money en masse. International EM investors, it seems, took the hit to their portfolios without significantly withdrawing cash.

If this is true, it suggests that holdings of EM assets remain hefty and may not have much room to increase.

“The basic message is that after all these years, people are sort of risked up,” said Mr Brooks. Not only that: today’s flows into EMs, he believes, consist of a rising proportion of retail rather than institutional investors.

“For each dovish surprise the incremental flow is less, and of worse quality,” he said. “It’s getting flightier and flightier. It’s not the long-term, sticky money that people need, because conviction levels are so low.”

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Kevin Daly, senior EM debt manager at Aberdeen Standard Investments, said the fact that people did not yank money from EM assets last year may also be because the pain across markets was widespread. In 2013, the Fed-driven shock was particularly severe for developing economies, whereas 2018 was a bad year for almost all risk assets everywhere.

In fixed income, bonds sold by EM governments in local currencies suffered particularly badly. They remain vulnerable to a dollar rebound this year, noted Mr Daly.

“Of all the headwinds that existed in 2018 and have faded in 2019, I would say that dollar strength is the one risk that could reappear in 2019,” he said. “So I’m not surprised that local currency debt has lagged hard currency debt.”

The Fed could, of course, change its view again. But if it does hold steady for the rest of the year, the key forces will be the US-China trade dispute and the broader outlook for the Chinese economy.

The outcome of the talks between Washington and Beijing remains hard to predict. And the reception of the latest Chinese car sales figures shows how nervy investors remain about the outlook for the world’s second-biggest economy. A fall in sales of new vehicles caused a wave of worry, perhaps unwarranted: used car sales are rising strongly as the market matures.

Mr Daly said January’s surge in EM bonds and stocks unnerved investors and prompted some to cash out. The current “slow grind upward” in EM assets, he said, is altogether healthier. It may be the best thing to hope for.

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