Risk assets have been in a real sweet spot since March-April 2009. Leading indicators of growth turned upwards, liquidity injections were at unprecedented levels, the Great Depression-2 was avoided and policy-makers seemed determined to skip any action which could spoil the party. How long can this intoxicating cocktail continue, where markets can see and bet on a recovery, but policy-makers are still too nervous to move on monetary and fiscal policy? It seems highly unlikely that this favourable environment can continue into 2010. Either growth will fade and rates stay low, or leading economic indicators like the ISM (Institute of Supply Management) will prove right, growth will take hold and policy-makers will be forced to move on liquidity and rates.
If growth truly continues to recover on a sustained basis, then policy rates will rise, liquidity will be withdrawn, and markets will have to deal with the dreaded exit policy and its consequences. Even if policy-makers want to delay normalising rates, their hand may be forced by fears of creating new bubbles in asset markets or spikes in oil and related commodities. Bond markets may leave policy-makers with little choice but to reverse the emergency measures of 2008 if growth were to surprise on the upside.
If, on the other hand, growth were to fade in 2010, then while policy rates may stay low, corporate earnings will be in serious question, and fears of a double-dip, further stress on the banking system et cetera will all resurface. Multiples will start looking very stretched if earnings do not come through. Markets are not particularly cheap even if stretched earnings forecasts come good, if earnings disappoint, valuations will look even higher. Exit from the current stimulus measures will look far-fetched, and markets may continue to worry about the dollar, fiscal sustainability and policy flexibility to handle further economic stress. There seems to be no political capital or financial resources available to deal with a further downshift in growth in the G-7 economies.
Between the two outcomes outlined above, which one is better for equity markets, specifically emerging market (EM) equities? Every market cycle has a sweet spot for equities like the one we are in now, and these cycles normally end with central bank tightening. Historically, however, the first move to tighten does not end the rally. The first move does cause market disruption, a correction and some type of sectoral rotation in terms of which sectors start outperforming/underperforming. However, equities can go on and make new highs. As Gerard Minack of Morgan Stanley points out in a recent note, in severe recessions, interest rates or rate expectations and equities can become positively correlated. In more normal times, they are negatively correlated.
If we get a scenario where growth in the US or, more broadly, OECD (Organisation for Economic Cooperation and Development) surprises on the upside, and interest rate tightening or an exit from the emergency measures of 2008-09 is faster than currently envisaged, then this could spell trouble for the EM asset class both on an absolute and a relative basis. Developed markets may perform in line with the thinking outlined above of the first hike not creating a peak in equities, but EM equities could falter. First of all, stronger growth and a quicker exit from QE (quantitative easing) will most likely strengthen the dollar, and cause a blip in the carry trade. A reversal of this crowded and perceived one-way trade is bound to have consequences for risk assets like EM equities. A dollar reversal is almost certain in the growth revival scenario as the US will most likely outperform the EU and Japan on the way to recovery.
A rise in rates in the OECD economies will also give cover to many EM central banks to embark on their own tightening. As it is, most market observers expect many of the EM central banks to lead the way in raising rates and tightening liquidity. Many policy-makers in the EM world have been constrained to an extent by the record low rates in the US and the EU. They will only get further emboldened in the above scenario. Tightening and liquidity removal will pressure equities in the relevant markets and act as a dampener more broadly on the whole EM asset class.
A reversal of the dollar trade (even if temporary) and tightening of domestic liquidity cannot be positive for EM equities (at least for the short term).
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If, on the other hand, we were to go down the route of there being a growth disappointment, and thus an inability on the part of central banks in the developed world to exit their fiscal and monetary policy measures, then in my opinion the EM asset class will continue doing incredibly well in both relative and absolute terms. In such a scenario, rates will remain low globally, the dollar will continue to be under pressure, the carry trade will be alive and, well, even the EM central banks will be more constrained in raising rates.
In such an environment, the growth differential between the large EM economies and the G-7 will only expand. Investors will also be willing to pay more for any growth visibility. As the folks at UBS point out, one of the best predictors of relative outperformance of EM equities is the relative gap in dollar-based nominal GDP between the EM economies and the OECD economies. This gap will expand in a weak growth scenario.
A potential double-dip will also spook investors in the US and the EU, as doubts on the capitalisation of the banking system resurface, fiscal sustainability comes in with renewed focus and doubts around a Japan-like lost decade once more come to the fore.
Capital flight out of the OECD economies will only accelerate as investors look for returns and growth in Asia. The current environment is unsustainable. Risk assets are in their sweet spot, with both very supportive liquidity and policy conditions, and hopes of a recovery in growth in 2010. Something has to give, either growth will disappoint and rates remain extremely low or rates rise as the growth bulls are vindicated. The likely path for EM equities’ absolute and relative performance is very different depending on which scenario unfolds. EM investors are probably better served hoping for a growth disappointment in the OECD world.
Investors should be careful about what they wish for.
The author is the Fund Manager and Chief Executive Officer of Amansa Capital