Declining trade value puts emerging markets at risk of Fed shock

(Bloomberg) — The Fed’s most tightening policy in two decades has been to drag emerging markets into a “sell everything” recession, not even spare assets that should do well when interest rates rise.

Take stock value. Stocks of mature companies with high dividends and cheap valuations are finding bids in the US and Europe, as investors turn to them from more expensive stocks in rapidly expanding sectors such as technology. But this so-called alternation of growth to value fails to occur in the developing nations, as both types of stocks diminish in tandem.

The inconsistency suggests that emerging markets may extend their underperformance against US stocks for the fifth year in a row. While previous hikes have coincided with rallies in developing countries, this time it may be more difficult because the Fed has not loosened its tightening with accommodative rhetoric as it did in, say, 2016. Indeed, liquidity is drying up around the world, leaving Investors with little appetite even to buy stocks.

“This goes back to the core philosophy of investing in emerging markets: you generally don’t want to stay in emerging markets for long until the Fed is basically gone,” said Nick Colas, co-founder of DataTrek Research.

Value stocks are usually preferred at the beginning of tightening cycles because their superior earnings and dividend yields help investors mitigate the impact of higher borrowing costs and the consequent revaluation of stock valuations. But now, that connection is broken. The MSCI Emerging Market Values ​​Index has fallen 13% in the past three months, slightly better than a 16% decline in the corresponding measure of growth stocks.

History tells a different story. During the 2004-2007 Fed tightening cycle, the measure of stock value rose 216%. In the two years to January 2018, its 61% rise coincided with Fed increases.

The main factor behind the random downtrend now is the strength of the dollar. The dollar imposes the same currency risk on all securities, regardless of relative valuations. That doesn’t leave traders much room to differentiate between them, especially when the US dollar surged to its highest level since 2016.

reverse goods

The major components of the world of value, inventory, commodities, and finance are beginning to fluctuate. The Bloomberg Commodity Index is headed lower since the April 18th peak, while Oil is down 13% since early March. Traders are retreating from their bets on currencies, bonds and commodity-based stocks, resulting in a 6% drop in capital inflows to the developing world over the past five weeks.

“Emerging market inflows tend to follow the strength of the dollar,” Art Hogan, chief market strategist at National Securities, wrote in an email. It’s been moving up and putting a huge impact on money flows.

The outbreak of the new Covid virus in China – and the country’s strict policy to contain it – has raised the specter of faster inflation and slower growth in the world’s second-largest economy. This can undermine demand for everything from raw materials to bank loans, leading to lower corporate performance.

“Headwinds prevail with sharply higher US Treasury yields and lower earnings ratings in China, removing risk appetite and money from emerging economies,” said Leonardo Belandini, equity strategist at Julius Baer. “Margin pressure will continue and high inflation will make it difficult to pass costs on to the consumer, while driving much lower global growth.”

In the meantime, interest rates are not rising everywhere. China, which typically accounts for a third of emerging market indices by weight, is cutting interest rates in response to economic hiccups. Other countries like Brazil are nearing the end of their hiking trips. This reduces the need for value rotation in these markets.

“Value rotation in emerging markets is operating at a completely different frequency this time around,” said Darshan Bhatt, executive vice president of investment and co-founder of Glovista Investments. “When you look at the interest rate cycle, emerging market countries are in a very different cycle than developed markets.”

Here are the top things to watch in emerging markets in the coming week:

  • Chinese exports likely suffered a major setback in April due to lockdowns in Shanghai and other parts of the country. Imports are likely to remain weak due to sluggish domestic demand and lockdown disruptions
    • Also, the People’s Bank of China is expected to cut the one-year medium-term lending facility rate to 2.75% from 2.85% in its operation in May.
  • Russia is set to report inflation accelerating further in April in the wake of sanctions, adding pressure on households
  • In Mexico, inflation is expected to extend its upward trend in April, rising further above the target. The central bank is likely to accelerate the tightening cycle by increasing the benchmark interest rate to 7.25% from 6.5%
  • Peru’s central bank is preparing to continue raising interest rates slowly despite the risks of falling behind the curve

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