Global Market Strategist
J.P. Morgan Funds
The act of "tapering" Quantitative Easing has not negatively affected emerging markets (EM), but rather expectations of U.S. short-term rate increases have disrupted the asset class.
Back in May and June of 2013, when Fed officials first mentioned the idea of "tapering," EM stocks fell 16%. Most assume the spike in U.S. 10-year Treasury yields was to blame for the turmoil in EM, but the reality is that a rising 10-year yield has no statistical significance with the performance of EM equities this year. In fact, I would argue that a rise in long-term U.S. rates on its own would be a positive for EM stocks since it encompasses the expectations of faster global economic growth.
The spike in the U.S. 2-year U.S. Treasury yield, on the other hand, spelled trouble for EM. A rising 2-year yield signifies that investors are expecting U.S. short-term interest rates (such as the overnight lending rate) to be higher two years from now. This is important for EM because over the past few years global investors have been borrowing dollars at abnormally low short-term rates and investing the proceeds in emerging markets. One example is that foreign holdings of local currency EM debt have increased from 9% in 2009 to over 25% in 2013*. In other words, the "carry trade" is funded with short-term Treasury bonds (not long-term), so a rising 2-year yield forces global investors to sell their EM positions and return their borrowed dollars (potentially at a loss).
The chart below illustrates the negative relationship between the U.S. 2-year yield and EM stocks. Since May, on average, for every 5 bps increase on the 2-year yield, EM equities saw a -0.32% drop.
Source: MSCI, U.S. Treasury, J.P. Morgan Asset Management
For illustrative purposes only
The good news for EM stocks is that since September, the Fed has been able to anchor short-term interest rates at very low levels. Using "forward guidance," they plan to keep overnight interest rates low for quite awhile. Tapering or no tapering, the calm or restlessness of the U.S. 2-year bond yield will dictate EM volatility in the coming months.
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International investing involves a greater degree of risk and increased volatility. Changes in currency exchange rates and differences in accounting and taxation policies outside the U.S. can raise or lower returns. Also, some overseas markets may not be as politically and economically stable as the United States and other nations.
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© JPMorgan Chase & Co., December 2013
*Emerging Advisors Group: "Still No Visibility on the Biggest Call in EM" Sept 23, 2013
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
Business relationship disclosure: This article was written by Andres Garcia-Amaya, Global Market Strategist, J.P. Morgan Funds. This article was submitted on his behalf via the J.P. Morgan Funds' Seeking Alpha profile.