Looking at the latest economic indicators such as purchasing manager indices and “hard” data on foreign trade and industrial production in the three major emerging market regions Asia, Latin America and Eastern Europe, the broad picture is of a sideways movement – i.e. neither a significant acceleration nor a significant slowdown in growth. Russia is one of the few exceptions. Following the sharp recession last year, the economy currently appears to be stabilizing at least.
So intensified capital flows to the emerging markets cannot be attributable to economic trends alone. The main reasons must lie in the EM environment. In recent months two external parameters have indeed favored investments in the emerging markets. Firstly, the protracted slide in prices of energy commodities, industrial metals and agricultural commodities has come to a halt. Although the picture is not uniform, prices of most commodities have at least firmed up in recent months. This reduces the pressure somewhat (not least on the currencies) of those emerging markets which are heavily reliant on commodity proceeds.
Secondly, contrary to prevailing market expectations early in the year, the US Fed has not nudged interest rates up further so far this year. Even if the Fed does hike rates one more time this year, the correction in US monetary policy is taking longer than had been widely assumed. At the same time, other central banks such as the ECB and the Bank of Japan have remained on an expansionary course or have even stepped it up further. The Bank of England also expanded its accommodative stance recently. All told, this means that the low interest rate environment will probably remain with us for a long time, with the global hunt for returns thus set to continue for now.
The emerging markets are benefiting from this hunt for returns without seeing a substantial improvement in their own economic situation. As a result, we can expect volatility in the capital flows between industrial and emerging markets to remain elevated in the months ahead. Should, for instance, the US Fed jack up rates more sharply and/or swiftly than the markets are currently expecting, investors could rapidly switch from risk-on to risk-off mode and withdraw capital from the emerging markets. The same might well occur given negative growth surprises in China or a renewed slide in commodity prices. Thus, current capital flows to the emerging markets can hardly be described as sustainable.
Download the full Working Paper below: