Are emerging markets losing their mojo?

If the dollar bottoms out and the ECB, BoE bring in tighter monetary policies, emerging markets could head south

Should investors who have made a fortune this year by investing in Brazil, Vietnam, India and Indonesia think of “rotating” out of these markets, seeking other shores? Well, it’s hard to spot a clear trend yet, but the proverbial tea leaves do advise a degree of caution.
 
Here is some data. After a spectacular rise of 26 per cent in the first eight months of this year, the MSCI emerging markets index (equities) recorded a decline of 0.5 per cent in September. While the deterioration was not substantial, the important point is that it happened after eight straight months of rising. Moreover, foreign capital flows to emerging markets (EM) recorded a decline for the second straight month in September and the month’s reading of USD 14.5 billion was in fact the lowest since January 2017. The Institute of International Finance (IIF), which tracks such data, noted that the seven-day moving average for its daily flows recently dropped to its lowest level since the US election in November 2016.
 
Looking at the Indian markets, foreign investors turned net sellers in September for the first time in eight months and took out USD 1.5 billion. As a consequence, the rupee depreciated by 2.2 per cent against the dollar in September. This was its steepest monthly decline since November 2016.
 
One could argue that the correction in EM assets should have happened earlier. Despite the impression that the US Federal Reserve has trodden way too softly, it has in reality already hiked its policy rate twice this year and is likely to deliver one more hike in December. It has also announced a clear plan to taper its whopping $4.5-trillion balance sheet built primarily on the back of quantitative easing. This is a phased reduction building up as it goes along and making bigger and bigger dents on the global liquidity cash pool. Add to this the fairly sustained signals of the prospect of monetary tightening from the two other heavyweight monetary authorities — the European Central Bank (ECB) and the Bank of England (BoE) and you get one of those killer recipes for an EM sell-off in anticipation of all this.
 
Clearly, the recipe has missed out a critical ingredient. The rally in EMs has lasted much longer than anticipated. There are two possible explanations for this.
 
First, compared to the previous monetary tightening cycles, the rise in US interest rates has been very gradual this time. Even the ECB and the BoE are expected to move gently when they do tighten. This gradual pace as opposed to a rapid burst of increases that typically happen in a rate hike phase has kept the opportunity cost of investing in emerging economies low. In short, the famous carry trade has remained alive and well.
 
More importantly, the weakness in the dollar for the major part of this year on the back of the US’ own brand of policy paralysis has kept EMs ticking. In fact, one of the most successful trades of 2017 has been to sell the US dollar and buy other EM currencies.
 
All this could be reversing now and the data on EM flows could be picking up the first signs of this impact. The US Fed is sounding more hawkish, looking to raise interest rates aggressively. If any of the candidates whom the US media sees as a likely successor to Janet Yellen makes the cut in February, US monetary policy could be considerably tighter than under the current regime. Besides, markets are once again becoming hopeful of Donald Trump’s ability to drum up bipartisan support for what many see as the silver bullet for America’s economic woes — tax cuts. So the anti-dollar trade that helped EMs is giving way to the pro-dollar trade that is by its very nature anti-EM. That simple logic clearly played out in September — as  capital flows to EMs dropped, the dollar index moved up (0.4 per cent) for the first time in seven months.
 
So here’s the big question for those who are still bullish on EMs. If the US dollar bottoms out with help from both Trump and a hawkish Fed, and if the ECB and the BoE join the bandwagon of tighter monetary policies, where do EMs head? “Head south” might just be the right answer.

Abheek Barua is chief economist and Tushar Arora is senior economist, HDFC Bank