The release of Federal Reserve minutes on Wednesday spooked investors, with the plan for continued quantitative easing (QE) set to come under the spotlight in March and policymakers divided over the Fed’s next move.
Latin American stock markets fell between 1% and 2% and the Chinese stock market was down 3% after the news broke. But analysts say that a potential decrease in QE will not cause investors in emerging markets to jump ship.
Emerging markets have been riding on the back of QE since it began in 2010, where the search for higher yields spurred dollar investors to look elsewhere.
“The perception is that the Fed was driving people to search for yield and thus capital was flowing into emerging markets. If QE was phased out or stopped altogether, flows into emerging markets would slow down,” says a US-based economist.
“This would also result in some damaging effects in the commodity markets there, which some emerging economies really rely on,” he says.
To boost growth and employment, the Fed pledged to buy $85 billion in long-term Treasury bonds and mortgage-backed securities each month. The Fed had initially stated that it would keep its bond buying program in place until there was a substantial improvement in the domestic employment market.
Some policymakers say the current strategy could create complications for an eventual Fed exit. Others warn continued QE could threaten financial stability. As a result, some Fed officials suggested a change in pace of asset purchases, while others put forward plans to scrap the bond buying all together.
How high is high
But analysts say the phasing out of QE, at a faster-than-expected pace, would not in itself trigger investor flight out of emerging markets. Instead, tight valuations will vex investors. “The best years for emerging markets are over,” says Bhanu Baweja, global head of emerging markets fixed income and FX at UBS. “Even if QE is phased out or stopped all together, independent of what has been said in the minutes, the degree of inflows we saw into emerging markets as recently as last year won’t be matched. Don’t expect 12% to 20% yields in various emerging markets to happen again anyway.”
Mark Dow, portfolio manager at Pharo Management, agrees. Writing in his blog, he says: “Commodities as a group have been underperforming equities for about six months now. The correlation between the two groups has been grinding lower. Even more important, I think the underperformance of commodities—and by extension emerging markets—will persist for some time.”
The first reason is that “emerging markets have downshifted their rate of growth,” says Dow. “Before the downshift we feared EM could grow to the sky, leaving many of us guessing at how intense the competition for scarce resources would become. We now have a better handle on ‘how high is high’.”
Secondly, “we have been coming around to a better understanding of monetary policy. We now increasingly get that the effects of monetary policy will be largely psychological and transitory until the deleveraging process approaches completion. At least, I hope we do. Otherwise, the fall in commodity prices will be deeper and the pain trade will last longer,” Dow continues.
The bigger concern is the worsening balances-of-payments position of many developing economies, piling on external financing risks. Therefore, one should not read too much into the minutes, says Baweja.
“There is always a different between what is recorded in the minutes and what is actually decided on. The one thing that can be made clear from the minutes, however, is that it was mainly the non-voting members of the Federal Open Market Committee (FOMC) that are worried about continuing with the same policy," he says.
“[Janet] Yellen [vice chair of the board of governors of the Federal Reserve System] and [Ben] Bernanke are at the core of the decision and are the most Dovish of the group. Their line would be to continue along the same trajectory for a lot more time.”