Tuesday, January 28, 2014

The EM line in the sand

Back in July, I wrote that the key risk to a Fed taper was a rising risk premium and the health of emerging market economies was a key indicator of how the market might re-price risk (see It's the risk premium, stupid!). Now the blogosphere has been buzzing about how a continuing Fed taper might sideswipe emerging markets. While it's nice to be ahead of the curve, it seems that the problems currently faced by selected EM currencies are due to local conditions, e.g. the problems in Argentina are unrelated to the problems in Turkey, and the risk of a global EM currency crisis sparked by Fed tapering is well under control.

I believe that US equity investors shouldn't get overly worried at this point, as EM tail-risk doesn't seem to be of a global catastrophic nature. Ed Yardeni recently made the point that US stocks have not been overly affected by EM crises in the past:
During the emerging markets crisis of 1997, the S+P 500 rose 31.0% that year with only one brief correction amounting to 9.6% early that year. There was a more significant correction of 19.3% in 1998 after the Russian ruble crisis and mostly in reaction to the collapse of LTCM. Yet the S+P 500 rose 26.7% that year.

History doesn’t repeat itself, but it does rhyme. The notion that an emerging markets crisis is bearish for the US stock market isn’t confirmed by the experience of 1997. Recessions are bearish for stocks. So far, it’s hard to see how the current emerging markets crisis triggers a recession in the US.
To be sure, some EM economies remain fragile. The IMF's latest World Economic Outlook Update warned about Fed tapering risks to emerging market economies
In emerging market economies, increased financial market and capital flow volatility remain a concern given that the Fed will start tapering in early 2014. The responses to the related December announcement have been relatively muted in most economies, possibly helped by the Fed’s policy communication and re-calibration (including revisions to forward guidance). Nevertheless, portfolio shifts and some capital outflows are likely with Fed tapering. When combined with domestic weaknesses, the result could be sharper capital outflows and exchange rate adjustments.

Key measures of EM risk
For investors who believe in the Fed tapering risk thesis, here are two key indicators to monitor especially as global markets wait for the results of the January FOMC decision and statement.

First of all, watch the relative performance of the EM bond ETF (EMB) against US junk bonds (HYG) as a measure of risk appetite in EM (EM junk vs. US junk). Despite all the hoopla about EM economies are tanking, the EMB/HYG ratio has tested and held a key relative support level.

Second, watch how currency ETF (CEW) to see how they react to the Fed decision. CEW is also testing a key technical support level and support has held, so far.

As I write these words, Turkey's made a surprise decision to hike overnight rates from 7.5% to 12%, which was much higher than Street expectations of 10%, and we are seeing a risk-on rally. Nevertheless, these are two key indicators of whether EM economies may have caught Taperitis.

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. (“Qwest”). The opinions and any recommendations expressed in the blog are those of the author and do not reflect the opinions and recommendations of Qwest. Qwest reviews Mr. Hui’s blog to ensure it is connected with Mr. Hui’s obligation to deal fairly, honestly and in good faith with the blog’s readers.”

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this blog constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or I may hold or control long or short positions in the securities or instruments mentioned.

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