The minutes of the Federal Reserve meeting, which showed some at the central bank are worried about the costs of quantitative easing, sparked a selloff in risky assets but analysts say that in the case of emerging markets, this is just a temporary correction.
Latin American stock markets fell between 1% and 2% on Wednesday after the Fed minutes were published; Asian stocks were also in the red, with Chinese stocks down 3%, while emerging European stock markets also fell by up to 2% on Thursday morning.
Among the sentences in the minutes that spooked the markets was this: “a number of participants stated that an ongoing evaluation of the efficacy, costs, and risks of asset purchases might well lead the Committee to taper or end its purchases before it judged that a substantial improvement in the outlook for the labor market had occurred.”
Some market participants believe the minutes to the January meeting raised the possibility that the size of the Fed’s quantitative easing program might be reined in sooner than expected, a scenario that seems a repeat of what happened after the release of the December minutes.
“I think we had a little bit of a fright this morning,” Peter Attard Montalto, emerging market economist at Nomura, told Emerging Markets.
“On a Fed exit, what people are thinking about in the long run is: do those flows in emerging market funds reverse and go back to the US, back into developed markets?”
“There is a grain of truth in that, that there is some hot money flow accumulation; but we think a lot of it is more structural, more of a real diversification into what have actually been low-volatility, easy-to- understand, better-to-invest than the eurozone universe [markets].”
Investors’ reaction to the minutes was, up to a point, normal, Neil Shearing, emerging markets at Capital Economics, said.
“To some extent it’s understandable, there’s widespread perception that actually what has inflated asset prices has been extremely loose monetary policy in the developed world and that’s created this wave of liquidity that went into emerging markets,” Shearing told Emerging Markets.
But he said that the evidence for that happening was “very thin.”
BIG TEST LATER
“I suspect in truth that the big test for emerging markets will come not with the end of QE3, but when the Fed actually starts to rein in this liquidity and starts to raise interest rates, which probably is going to be for some time yet,” Shearing said.
Even though there is a lot of money created by developed countries’ central banks that is flowing into emerging markets, many inflows are actually more permanent ones. Nomura’s Montalto says there are Asian pension funds which “have been seen going in places like Poland more recently,” a lot of sovereign wealth funds, and US real money – such as pension funds – driven by structural asset reallocation that is part of a long-term strategy.
“These are all more sticky and for the long run,” he said.
Montalto expects market participants to get over this “shock to risk premia” as they realize that unemployment in the US is likely to “remain extremely high for a very long time” and that, even if the Fed doesn’t do additional quantitative easing, monetary conditions will remain extremely loose.
“And you have Japan coming in in the US’s place, doing its own, probably very aggressive, monetary easing,” he said. “The yen is already a funding currency, and will become more so.”
While Shearing does not believe that Japan will replace the Fed in terms of quantitative easing, as its asset-buying is likely to begin only in 2014, he thinks Thursday’s fall in risky assets is just a correction, as the rally since the end of last year was “a bit overdone anyway” and “this just tempers the more extreme optimism.”
“The major disruption to the rally in risky assets and emerging market assets is more likely to come from Europe, I think, and a re-escalation of the debt crisis,” Shearing said.
He believes that the underlying problems for the eurozone remain and that, despite progress on a banking union in the single currency area, some structural reforms and European Central Bank president Mario Draghi’s pledge that the bank will do all it can to protect the euro, the crisis can resurface.
“Frankly, it can happen at any point,” Shearing said.
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