A friend from a global macro hedge fund asked me after the surprising ECB rate cut followed by a fairly strong US employment report:
Tell me, why do we even bother about EM anymore?
I honestly didn’t know how to respond…
There are two ways of looking at the issue here. Due to my day-to-day occupation I will start with the glass-half-full one.
1. The global cycle is turning
I have been noticing a very peculiar divergence in various sets of data globally. On the one hand activity indicators are looking far stronger than anyone would have anticipated six months ago or so. The US is storming forward if one adjusts for the fiscal thrust, the Eurozone is out of the recession and Chinese 7%+ growth hardly looks like a hard landing. And yet the world is paranoid about deflation…
Yes, if you look through my previous posts you might notice that generally I used to be a proponent of loose monetary policies in the face of wide output gaps. But I don’t think this is valid anymore. I treat a lot of the current disinflation as a supply shock (have you seen food prices lately?) and I fully subscribe to Draghi’s “you can buy more stuff” view. Likewise, potential growth rates have shrunk dramatically so it is not entirely obvious it will take years to close the output gaps. All in all, I do see current low inflation as merely a reflection of the past rather than anything to be concerned about.
If that pseudo-analysis is anything to go by then the current disenchantment with emerging markets is only temporary. Why? Well, because the market is confused like during each and every turn of the cycle in the past and therefore even the liquid stuff allows for decent volatility. And if nothing is trending (in fixed income at least) then why bother with extra, EM-specific issues.
2. The market has changed
This is something that is a bit of my darkest nightmare to be honest. If I am wrong about the turn in the global cycle the period of trendlessness will continue unabated. And if so then the short-term players will naturally focus on punting in G3 markets while long term investors will make sure they don’t trail their benchmarks too much. This is already happening — I track a lot of EM funds benchmarked to the JP Morgan’s Global Bond Index and I can’t remember the last time the tracking error was so small. And to be perfectly honest, I don’t blame them as indices like that are difficult to beat in an environment like currently and the upside is very limited.
I like to think that not all is lost and once a medium term direction is established, investors will return to EMs en masse. After all, there’s some unfinished business to do — rates in Brazil, Turkish lira, Russian ruble, Mexican Bonos, Polish zloty… These are only a few examples of things that you don’t need vivid imagination to dub “severely mispriced”.
But I guess for now we will be in a “taper on / taper off” type of trading…