As of 15 February, the MSCI World index, a gauge of developed countries’ equity markets, was up 4.7% this year in dollar terms, while the MSCI Emerging Markets index is up 9.2%.
Why have emerging markets done better?
The recent Bank of America-Merrill Lynch survey of global fund managers has the answer—fund managers shifted from a net 6% underweight in January to a net 5% overweight in February, the biggest month-on-month jump in net allocations to emerging markets in the last eleven months.
But what prompted fund managers to increase their allocations to emerging markets? The answer lies in the US dollar. Says the fund managers’ survey (FMS), “Feb FMS shows consensus strong-$ view faltering at margin with rotation to EM, energy & materials (largest overweights since spring’12).” A stronger dollar, of course, lowers returns from foreign assets for US investors.
The strength of the US dollar, the result of higher Fed rates, higher bond yields and Trump’s promises of fiscal stimulus, led to money being pulled out of emerging markets at the end of 2016. But that ‘reflation trade’ is fraying at the edges, simply because it is the most crowded trade.
The BofA-ML survey says that is a big reason why the USD is down year-to-date. The fundamentals—higher US interest rates, a stronger US economy—seem to be in favour of the greenback. US Federal Reserve chairperson Janet Yellen’s recent testimony has led to the market revising its view of hikes in the Fed Funds rate.
The CME Fedwatch tool, which computes probabilities of the Fed hiking rates based on data from the futures markets, shows that the probability of the Fed hiking rates at its March meeting moved up from 17.7% before Yellen’s testimony to 26.6% after it. And the probability of a hike at the Fed’s May meet is now over 50%.
Yet, on the other hand, positioning in the market in favour of a strong dollar is already extreme.
The proportion of investors who think the dollar is overvalued is the highest since 2006, says the BofA-ML survey. But allocation to emerging market equities is still 0.6 standard deviations below its long-term average, so there’s plenty of scope for it to improve.
The second most crowded trade, according to the BofA-ML indicator, is shorting government bonds. While the fundamentals of the US economy favour higher bond yields, short positions in bonds are already high.
There is thus a tug-of-war between the fundamentals, or rather what investors believe are the fundamentals and positioning. Of course, cash levels with fund managers also matter in the short run. According to the survey, cash levels fell to 4.9% in February, down from 5.1% in January, as fund managers put some of their cash to work.
Cash is still at elevated levels and at the same time expectations of global growth and inflation among investors continues to be high. That combination indicates strong support for equity markets.
Investors now believe the US economy is strong enough to weather hikes in US interest rates and fund managers say yields are too low at present to hurt stocks. For emerging markets, the additional factor to watch out for is the strength of the US dollar.
That said, fund managers believe the biggest risk to markets lies in Trump’s protectionist tendencies and the best hedge against that risk is gold.