By Chris Dillow, 21 February 2012
Equity investors don't, I suspect, think very often about performativity. But perhaps we should, because it might be very bullish for emerging market shares in particular.
The idea of performativity is simple. A performative statement is one that creates the conditions it describes. This could be true of the Federal Reserve's interest rate forecasts.
Eleven of the 17 members of the Federal Open Market Committee forecast that the target for the Fed funds rate will stay at 0.25 per cent until the end of 2013, and only two expect it to be above 1 per cent then.
These forecasts might be performative, in that they don't just describe future monetary conditions but create them. This is because people have an urge to be consistent. As Robert Cialdini, a psychologist at Arizona State University has written: "People generally prefer their behaviours to be consistent with their pre-existing attitudes, statements, values and actions." Having forecast low interest rates, then, FOMC members might be biased towards delivering them, even if economic conditions might not entirely warrant them.
For investors, this raises a delicious prospect. It means the risk of an early or sharp rise in US interest rates is small, which increases the attraction of assets that traditionally benefit from cheap money, such as commodities and emerging market shares.
The obvious precedent here is the early 1990s. In 1992 the Fed cut interest rates to a then-remarkable 3 per cent to deal with a financial crisis – the Savings and Loans debacle. This led to emerging market equities soaring by 80 per cent in the space of just 14 months, between November 1992 and January 1994.
And this rise was only reversed after the Fed began to raise rates. As long as rates were low, emerging markets did well. The Fed therefore caused both boom and fall in emerging markets.
A similar thing happened in the early 00s. In 2002-03, the Fed gradually cut the funds to 1 per cent. And in the 12 months to March 2004, emerging market stocks rose 80 per cent in US dollar terms. On that occasion, they continued to rise as the Fed returned rates to normal – but at a slower pace.
This precedent suggests that investors can safely buy into emerging markets (and other beneficiaries of cheap money) because the Fed creates bubbles.
However, the link between US monetary policy and bubbles isn't always so tidy. The 1999 bubble in technology stocks inflated while interest rates were actually rising, and burst before they peaked. Economists believe one reason for this was that, in 2000, lock-in agreements – which had prevented owners of firms that floated in the late 1990s from selling their shareholdings – expired, thus causing heavy selling by insiders.
Which poses the question: if rising interest rates don't burst a bubble in emerging markets, would a wave of selling do so?
It's unlikely that fundamental investors would sell a lot if they believe the markets to be overvalued. It's very risky to go short of an entire asset class, especially as volatile a one as emerging markets.
The likeliest source of such selling would instead simply be negative sentiment. One possible cause of this would be a sharp slowdown in the Chinese economy. Ashley Davies at Commerzbank says there are "downside risks" to growth, but believes they can be contained by looser monetary policy.
Another possibility would be that the US economy's hitherto surprising strength goes into reverse, causing a decline in investors' appetite for risk.
You can interpret these risks in one of two ways. On the one hand, they are reasons to suspect that a Fed-blown bubble might not happen, and that there are good reasons to hold some cash.
On the other hand, these are reasons why the bubble hasn't yet inflated fully, and so the markets will offer nice returns if these dangers don't materialise. As the old cliché said, markets climb a wall of worry.
My point here is simple. Even at these apparently high prices, there is upside risk as well as downside risk to emerging markets. We should not ignore the power of cheap money. And if a bubble does emerge, do not get carried away by the self-justifying hype that always accompanies rising prices; it'll just be cheap money doing what cheap money does.
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