Fed tapering and emerging markets

One of the big risks for emerging market (EM) financial assets in 2021 is the one of a tapering of asset purchases by the US Federal Reserve, something which will be eventually followed by other G-7 central banks.

The balance sheet of the US Federal Reserve has ballooned dramatically since the global financial crisis. In 2008, before the global financial crisis, the size of the balance sheet was about $1 trillion. Today that is almost $8 trillion. The size of the balance sheet rose by $3 trillion in March-May 2020 itself as the Fed hit panic stations and pulled all the levers at its disposal to stabilise the financial system. Even today the US central bank is buying bonds at the rate of $120 billion a month to support the economy and keep financial conditions very easy. Supportive financial conditions are seen as critical to kickstarting growth and employment.

Given the pace and scale of the expected economic recovery in the US, for context, the US, besides China, is the only major economy that will end 2021 at a higher absolute level than forecast before the pandemic. It is, therefore, only a matter of time before these bond purchases are scaled back, the so-called tapering. While Fed Chairman Jerome Powell continues to insist that it is too early to even talk about tapering, markets may give him no choice. Inflation concern is rising in the US, and most market observers accept that there is a real possibility that inflation breaks out. Yields are rising, the inflation breakeven is at a multi-year high, and bond/stock prices are positively correlated again. In fact, in the minutes of the Federal Reserve meeting in April, some of the governors raised the idea of beginning to discuss a possible tapering.

Markets are fearful, as we went through something similar in 2013, when then Fed Chairman Ben Bernanke spoke about tapering for the first time in May 2013, related to winding down the QE3 bond-buying programme. The very possibility of a reduction in asset purchases created extreme volatility in financial markets. The period of risk aversion and heightened volatility became known as the taper tantrum and lasted from May to August that year. During this short window of four months, yields on US long bonds rose by 130 basis points, rising from 1.6 per cent to almost 3 per cent. Real yields surged by 160 basis points from minus .75 per cent to .85 per cent. Even though the Federal Reserve did not actually start pulling back on bond purchases until December 2013, in the short window of three to four months after Mr Bernanke’s initial comments, the damage was done. EM equities declined by 11 per cent and EM sovereign bonds by 13 per cent. In a short span of 35 days, $30 billion was pulled from the asset class -- a bigger and quicker exit from EM assets than what had occurred after the global financial crisis in 2008. Rising US yields caused global investors to reassess the attractiveness of non-US assets. The search for yield was not as extreme.

While the initial EM selloff was indiscriminate, the focus of the selling was eventually targeted at the so-called fragile five economies (India, Brazil, South Africa, Turkey, Indonesia), all of which had large current account and fiscal deficits. Dependent on global capital, risk aversion drove these five economies to raise rates to protect weakening currencies. The economies of all five suffered. India resorted to NRI bonds to shore up its reserves and rebuild investor confidence. It was a very difficult time for the asset class and these five markets in particular.

Illustration: Binay Sinha

The parallels with today are obvious. Will we see another taper tantrum? Will the EM asset class once again suffer, with the weaker economies hit disproportionately?

While anything is obviously possible, the fact that investors are conditioned and thinking about a taper tantrum should by itself reduce the shock and market volatility. It will be less of a surprise than 2013. The Federal Reserve is also very conscious of the impact Mr Bernanke’s words had in 2013, and the fact that markets were not prepared adequately. They will not make the same mistake again. Signalling will be better.

Real yields have already moved up from extreme levels and some of the yield adjustment has been done.

While there will be volatility and some choppiness in markets, only to be expected, given how well financial assets have done and the level of valuations, the reaction should be more moderate than in 2013.

As for emerging markets, the external balance of most of the countries is far better today. Among the countries of the erstwhile fragile five, all except Turkey have dramatically improved their current account balance and forex reserves and reduced their dependence on external capital. There should be no run on their currencies this time. While fiscal deficits are much higher, as are public debt burdens, this is true globally.

The bad news for the asset class is on growth. Given the differential on vaccines and their roll-out, immediate short-term growth in emerging markets will lag the developed world. However, the harsh truth is that if we look at emerging markets ex-China/India, growth in per capita incomes has lagged the developed world since 2014. The growth story has just not played out, especially ex-Asia. This may now change if we are in a commodity super cycle as some EM bulls now believe.

The other big difference between today and 2013 is in the dollar. In 2013, the dollar was low and rising against all EM currencies, while today most experts believe the dollar is poised to continue weakening. A weaker dollar favours emerging markets.

While a reduction in bond buying by the Federal Reserve is inevitable, a consequent big selloff in the EM asset class is not necessarily a given. A repeat of the taper tantrum seems unlikely. EM assets are normally a derived play on global demand. The year 2021 will be one of the strongest years for global growth in history. It seems unlikely that investors in the asset class will get spooked out of their positions by taper talk.    

The writer is with Amansa Capital