The Fed’s Liquidity Inflow Lament
Pre-pandemic historically, aggressive US Federal Reserve loosening – cutting rates to record lows along with balance sheet expansion – drove investors into emerging markets debt, equity, and currencies in search of yield. Even after the massive stock and bond selloffs during the GFC and the 2013 “taper tantrum,” fund flows into emerging markets returned within months seeking assets in faster growing economies and offering better returns than in the US and Western Europe. Conversely, a surprise rate hike in the US in 1994 sent funds fleeing emerging economies, resulting in massive foreign portfolio outflows pressuring currencies with some experiencing balance of payments crises. For example, Turkey with inflation running at 150% and a current account deficit of 3.5% of GDP, had to turn to the IMF, while that year ended with the Mexican peso devaluation induced “Tequila Crisis.” In the mid-1990s, the universe of liquid, “investable” markets was limited, and the peso crisis spread as the relatively small number of dedicated EM investors fled, particularly throughout Latin America.
Today even with central bank benchmark rates in the US, UK, EU and Japan either at rock bottom or negative and as the G-4 monetary authorities massively expand their balance sheets, up by some USD 6 trillion collectively since the start of the Covid crisis, inflows to emerging markets remain subdued. While many stock and bond markets and currencies have rebounded since the sharp early year sell-off, investor commitments to EM remain muted and selective. The MSCI EM Index is up more than 30% from its March low, while the average yield on JPMorgan’s local currency government bond index has fallen nearly 2%.
Economic and financial market crises in global markets have historically resulted in EM central banks hiking rates to stem portfolio outflows and to avoid the associated spike in inflation w currency depreciation. The pandemic has upended the traditional response. Instead of tightening, monetary authorities have not only slashed rates in an attempt to soften the economic impact of the pandemic, led by Turkey with 1,575 bps. in cuts the twelve months, but some have also turned for the first time to “quantitative easing” unconventional policies. For example, central banks in Indonesia, Poland, and South Africa are buying government bonds, while their counterpart in Colombia is supporting the corporate bond market.
Through mid-August, emerging market equity funds have recorded outflows of USD 42.2 billion while bond fund outflows top USD 21 billion, according to fund tracker EPFR Global. The Institute of International Finance, which tracks the 25 largest emerging markets, reports that inflows have rebounded unevenly. After a record USD 83.3 billion was pulled from EM stocks and bonds in March, net inflows were recorded in June and July, with nearly 90% of the funds directed towards bonds. Emerging market equity exchange traded products ( ETFs), which account for half of allocation, recorded $2 billion net inflows in July for the first time since January, while flows to ETF debt products have been “overwhelmingly” directed to hard currency bonds since money began to tentatively return in April, according to iShares.
As has been the case following every global or EM crisis for decades, the rebound in fund flows illustrates the changing weight of benchmarks against which to measure fund performance and intense investor scrutiny of debt, deficit, currency, and foreign exchange reserve levels. China, viewed as “first in-first out” of the Covid crisis, accounts for 20% of the MSCI Emerging Markets Index. As its economy shows mixed signs of recovery with a relatively stable currency against the greenback and it was added to major bond indices, China has attracted USD 66 billion to its local bond market this year, almost equal to total inflows in all of 2019. In contrast, Turkey has seen total portfolio outflows of over USD 12 billion this year as the central bank drained FX reserves to try to support the currency before letting it depreciate this month to new record lows. The country’s benchmark index positions are increasingly marginalized, as foreign investors now hold only USD 26 billion in local stocks and bonds, the latter with negative real yields with inflation running over 11%.
The global pandemic crisis is the first in which both emerging and developed economies are projected to contract. In the wake of the GFC, global GDP was -1.67% in 2009 but emerging markets grew 2.6%. This year the IMF expects global growth at -4.9%. However, emerging economies are expected to shrink less than advanced ones with a stronger rebound in 2021. The IMF’s most recent projection is for the former to contract 3% and rebound 5.9% in 2021, while it expects the latter at -8% and + 4.8%, respectively. As Covid-19 rages, investor re-engagement and a rebound in fund flows to emerging economies will remain subdued in the near-term. Hard and local currency bonds from “safer” investment grade sovereigns and corporates, will lead the rebound. Listed equities in emerging economies, both domestically oriented firms and exporters, will continue to struggle to attract foreign investors on poor virus and cycle bottom earnings. Double-digit unemployment will spread, while global trade is projected by the IMF to fall at least 10%. Even doing “whatever it takes,” as the ECB promised during the height of the Eurozone crisis & implied again early this year, the US Federal Reserve and advanced economy counterparts can no longer in lockstep reignite global growth or fund flows to emerging markets.