The ‘Fed Put’ is back

However, we are still being selective about Emerging Markets due to the idiosyncratic risks that continue to plague some of these economies.

We are positive on the Indonesian rupiah (IDR) but, are holding long tactical positions in the Argentine peso (ARS) and Turkish lira (TRY) given their high carry.

We are long on Chinese equities. Additionally, we see value in other Emerging Markets, such as the Russian rouble (RUB), South African rand (ZAR), Mexican peso (MXN), and Brazilian real (BRL).

However, we would need to be convinced of these countries’ reform agendas and growth prospects to see an extension of their rally.

After a difficult 2018, Emerging Markets have somewhat made a comeback this year, thanks to the Fed.

After hiking four times in 2018, US dollar funding conditions across Emerging Markets became more difficult to secure and Emerging Market assets sold off.

Emerging Market policymakers were forced to react; as contagion was pervasive.

In response to capital outflows, Indonesia, for example, hiked rates by 175 basis points (bps) to maintain attractive yields for investors even though inflation was low.

Countries with large current account deficits and who are dependent on US dollar funding, such as Turkey and Argentina, saw their currencies significantly depreciate.

Then, at the Federal Open Market Committee (FOMC) meeting in January, the Fed vowed it “will be patient as it determines what future adjustments to the target range for the federal funds rate may be appropriate.”

The FOMC meeting was non-committal in terms of timing of its next move, as well as direction.

The other key fundamental shift from the FOMC is that, if necessary, they are prepared to adjust the balance sheet. Previously, it was viewed that the Fed’s balance sheet was on ‘autopilot’.

Inflation was not a threat, but the Fed took their message a step further at their March meeting.

They eliminated any hikes for this year, after initially pencilling in two, and announced that quantitative tightening would end in September.

Meanwhile, their growth forecasts were above trend for 2019, and at trend for 2020 and 2021. Basically, the Fed is telling the markets that it wants to prolong the current cycle and the economy is at around a neutral interest rate level.

In a nutshell, Goldilocks is here to stay.

Now that the Fed’s policy intentions are clear, market volatility should continue to decline (see Fig 1 & 2), which means risk assets should do well.

Figure 1: Decline in global foreign exchange volatility¹

Figure 2: Decline in Emerging Market asset volatility²

After the Fed emphasised in January that it needed to remain patient on hikes, we believed the ‘Fed Put’ was back.

As such, we changed our Emerging Market view from ‘slightly underweight’ to ‘slightly overweight’.

We have even taken positions in local currencies that were severely wounded in last year’s sell off; including the two high carry currencies, TRY and ARS, because we believe US yields and the US dollar will remain stable or even decline.

This environment should be supportive for Emerging Markets.

Yields in the G10 space – barring the US – are still near all-time lows and investors will look to Emerging Markets for higher returns.

Year to date, the US dollar’s performance has been mixed, but mostly weaker versus Emerging Market currencies.

While the benign Fed environment should bolster Emerging Markets, idiosyncratic risks linger.

The likes of Argentina and Turkey still need to prove to the markets that they will adhere to their reform agendas.

Brazil, Mexico, and South Africa will need to continue to surprise the markets if they are to see a sustained rally.

While we await further confirmation on the reform agenda, one key risk has been taken off the table.

With the US dollar stable, investors may as well benefit from these higher yields.