One of the biggest casualties of the taper tantrum in mid-2013 and early 2014 were the stock indices of Emerging Markets. Of course, both drawdowns were followed by prompt buying as for all concerns about fund flows, the carry trade proved to be alive and well, whether due to ongoing QE by the Fed (and the broken market's inability to price in tapering by the same Fed which has manipulated it to all time highs) or rumors that either a European QE or a boost to the Japanese QE are just around the corner.
But is there anything fundamental to explain why the equity indices of the "Fragile Five" countries, Brazil, South Africa, Indonesia, India and Turkey, have regained their recent highs? According to GaveKal the answer is a resounding no: "As investors, we like equity rallies to be propelled by fundamental factors, like earnings re-ratings or growth surprises. But there is little behind this rally to suggest any sustainable economic healing." So what is pushing this particular subset of risk higher? Why the global liquidity tsunami of course.
From Evergreeen GaveKal
Emerging Markets Carry Trade Looks Vulnerable
Over the last two months, emerging markets have delivered a handsome rally, with the MSCI emerging markets index recording a 7% return in US dollar terms, compared with just 1% for the developed markets. The trouble is that this rally has been driven primarily by investors’ growing enthusiasm for carry trades in an environment of declining global volatility. Experience teaches this is an engine which can all too suddenly be thrown into reverse.
The defining feature of the current run-up in emerging markets is that the greater the sell-off a country suffered last year, the stronger the rally it has enjoyed this year. As a result, the so-called “fragile five”—Brazil, India, Indonesia, Turkey, and South Africa— the markets most reliant on foreign capital and so most vulnerable during last year’s taper tantrum, are no longer looking quite so fragile. Since their lows in January, the Turkish lira has surged 13%, the Brazilian real 10%, the South African rand 8% and the Indonesian rupiah and Indian rupee 6% each.
It hasn’t taken long for the rebound to flow through to stock markets. In local currency terms, an investor with an equally-weighted allocation to each of the fragile five’s equity markets will already have seen his portfolio regain its previous high reached in May 2013.
As investors, we like equity rallies to be propelled by fundamental factors, like earnings re-ratings or growth surprises. But there is little behind this rally to suggest any sustainable economic healing. Sure, there are pockets of earnings re-ratings because of last year’s currency depreciation, but we see little in terms of broad-based economic surprises. According to the Citi Eco Surprise Index, economic data in the emerging market has largely surprised on the downside so far this year. Most forward-looking indicators, especially in Asia, are signaling no prospect of any decisive upturn in the growth outlook. What’s more, the prevailing direction of economic and monetary policies is hardly investor-friendly. Credit moderation remains the order of the day in China, while policy settings have been on hold among many of the other major emerging markets in the run-up to national elections. And with food prices turning up, monetary easing is now off the table for emerging market central bankers.
That leaves the search for carry as the principal engine of the current rally. The markets which sold off most violently last year, and which have rebounded most strongly over the last couple of months, are those offering the most attractive yields. As volatility in global financial markets fell this year, and lingering fears of emerging market (EM) contagion evaporated, the lack of yield on cash prompted investors to turn once again to the high yielding emerging market currencies and fixed income markets which took such a beating last year.
The widespread return of calm which has underpinned the revival of the EM carry trade is marked, and even ominous. Unless you are trading the renminbi or the Russian market, volatility levels in major equity markets, currency pairs, Credit Default Swap (CDS) spreads and basis swaps are once again approaching, if not already below, the lows seen last April. Even Chinese CDSs are at year-to-date lows, despite the worries over China’s growth trajectory, while volatility in the Brent crude market has fallen even as geopolitical uncertainty has mounted. While low volatility is nothing new in the era of financial repression, it still signals a remarkable rebound in confidence given expectations that the Fed will halt its balance sheet expansion within a few months.
On this premise, the moment that volatility returns, the EMs will be extremely vulnerable to investor repositioning. Quite what the trigger might be is impossible to say. But history teaches us that volatility rarely stays this low for long.
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History, also teaches us the central planning on such a grand, global scale always ends in tears too, but for now the music is playing and the dancing, on "other people's tab" must go on.