Lessons from the past

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Emerging market equities are likely to be resilient to tighter US monetary policy

Although a market correction was widely expected, the US-led equity sell-off on July 31st came as a surprise. With the S&P 500 at all-time highs, volatility (VIX) approaching record lows and an absence of market corrections greater than 1% since March 2014, it was indeed just a question of time before stocks began consolidating.

As usual (with known unknowns), the timing of the market’s stumble was unanticipated. As so often is the case, there was no apparent catalyst for it. Argentina’s default (its fourth in the last 25 years), the escalation of violence in the Middle East, the Russia/West standoff over Ukraine, disappointing earnings reports and the largest monthly decline in the Chicago purchasing managers confidence index since 2008 were among the pieces of “bad” news behind the fall.

The more likely reasons for the market retreat, were probably (and paradox ally) the “good“ news in the form of the strong-than-expected second quarter US GDP report and the US job figures

As was the case in May 2013, the strength triggered concerns that it may prompt the Federal Reserve (Fed) to accelerate “monetary policy normalisation”. The Fed’s acknowledgement of recent improvements in the economy, as well as momentum in prices towards the Fed’s 2% annual inflation target certainly did nothing to dispel these fears. Nor did the dissent by Philadelphia’s Federal Reserve President Charles Plosser, the first in almost seven years, to the Fed’s commitment of holding interest rates near zero “for a considerable time” after the QE3 bond-buying stimulus ends (forecast for October).

Against this backdrop, one question which immediately comes to mind is whether this market downward correction signals at the start of a downturn in equity markets? We do not know (another known unknown). However, some elements seem to indicate that at this juncture the market’s drop should be seen as a technical pullback in a mid- to long-term upward trend, rather than the start of a new equity bear-market. For example, if there was indiscriminate selling across asset classes during the first day of the correction, differentiation between asset classes was already evident by the next day. Also, while emerging markets were also negatively impacted, it was interesting to note, that most fared better than developed markets; some of the so–called “fragile five” markets, namely India, Indonesia and South Africa proved in fact more resilient than their developed peers.

This raises a second key question, namely how emerging markets equities will react to a Fed target rate hike or heightened expectations of the same. In attempting to answer this we’d analyse two key episodes of US rate hikes in 1994 and 2004. We do not consider the “intermediary” tightening of monetary policy between June 1999 and May 2000 since it represents, in our view, the resumption of the cycle of rate hikes that began in June 1994, but were interrupted by the Asian financial crisis. “Pre-emptive ” tightening, as Alan Greenspan referred to it as, was necessary against the backdrop of an economy running at an unsustainable annual growth rate of 5%, despite inflation being well below the target rate.

The graph below demonstrates that emerging equities suffered during the 1994 Fed rate tightening episode, but rallied sharply in 2004.

Historical Fed Funds Rate plotted against MSCI Emerging Markets
fed Source: BNPP IP? Bloomberg, August 2014
Three elements essentially explain the different outcomes:

First, the 1994 hike in US rates caught markets off guard and was very fast, with rates being hiked in a single move by 75 bp in November 1994. Federal Open Market Committee (FOMC) Chairman Alan Greenspan did not believe in signalling the Fed’s intentions at that time, and the Fed funds rate was raised by 3% to 6% in just one year.

By 2004 the efforts of FOMC member Ben Bernanke, had led to a change – he believed Fed communication has to be transparent to increase policy effectiveness. He of course succeeded Greenspan in February 2006. Markets were at this point well prepared for monetary policy tightening and were able to anticipate the Fed’s next moves, which incidentally never exceeded 25 bp per hike. In this case the rate hike cycle, which brought rates up from 1.25% to 5.25% lasted 2 full years and started two and a half-years after the shallow 2001 recession.

In addition the US economy grew well above previous levels at ~4% when the rate hike cycle started in 1994, while core inflation was slightly above target at 2.3%. Overheating risk was then the Fed’s key preoccupation, which explains the fast pace of rate hikes resulting in a sharp growth deceleration in 1995. Economic activity was more balanced on a broader base though, with global GDP expanding 3.5% on average between 1994 and 1996. Inflation on the other hand was very imbalanced. Latin America was plagued by hyperinflation, and Asia saw prices grow 9% on average, while the rates of consumer price inflation (CPI) in developed economies were slightly above their targets at around 2.5% on aggregate.

Broadly speaking the growth/inflation picture was better balanced during 2004-07. Similar to 1994, but to a lesser degree 2004, US GDP initially was expanding at a rate above potential, but core inflation was marginally below target. Global GDP grew quite regularly at a 5% clip per annum from 2004 to 2007, while global inflation was close to a quite benign 4% on a yearly basis.

Furthermore, equities entered the two above mentioned Fed funds tightening episodes at quite different valuation levels. The emerging markets (EM) equities’ forward PE ratio stood at a notable 21x in 1994, compared to a modest 8.8x in 2004. Developed market (DM) equities’ PE started 1994 at 19.4x, and 2004 at 16.1x. Interestingly, relative valuations of EM versus DM equities led to an underperformance of EM equities in 1994; conversely, for opposite reasons, the latter largely outperformed their developed peers in 2004. Also worth mentioning is the fact that 10-year Treasury-yields were almost 1.5% lower in 2004 than they were in 1994, providing an additional support to the 2004 equity rally.

The current context has a closer resemblance to the situation prevailing in 2004 than 1994. In fact the Fed, like most other central banks, is more cautious than ever in preparing the market to changes in monetary policy. The route toward the end of tapering in October has been traced for months. The Fed’s statements make it clear that the move towards higher central bank rates will be cautiously engineered by a Fed not willing to take any asymmetric risk on the markets and economy.

What’s more if we leave out of the frame any exogenous disruption, broad-based non-inflationary growth looks like the most likely scenario moving forward. The IMF forecasts 4% per annum global real GDP growth from 2015 to 2017, the period when the Fed is expected to increase the Fed funds rate. The Fed will likely have enough room to act at a measured pace since US GDP is not expected to increase by more 3% over the period, a level which will likely keep inflation within the target range. Against such a backdrop, a quick withdrawal of liquidity does not seem very plausible. Nor does a sharp rise in Fed Funds rates and/or bond yields, which the FOMC wants in any case to keep low.

Finally, market valuations, while somewhat richer than in 2004 are far less stretched than in 1994. Emerging markets PE’s currently stand at around 11x compared to approximately 15x for developed markets (16x USA). Incidentally, as was the case in 2004, relative valuations favouring EM equities hint at outperformance of this asset class versus its developed peers.

To conclude, not-too-hot, not-too-cold US activity, gradually healing in the euro zone, stabilisation in China and a stronger Japan, combined with still abundant liquidity and modest rise in bond yields are factors that remain equity (and credit) supportive.

If history is a guide, EM equities should benefit more this time around from the context, since their valuations are cheaper than those of their developed peers. To be sure, once financial markets witness the start of a policy-tightening cycle from the Fed, possibly as soon as early 2015, and start to discount a higher cost of funding, selling pressure will again materialise. Any such consolidation should however be taken as an opportunity to add to the equity position, especially in emerging markets, since any tightening in monetary policy will likely also raise confidence in more sustainable economic growth and profits.

Patrick Mange

Head of Investment Strategy for Emerging Markets

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