Emerging markets' Fed fears

To see this, we need to know the impact of US monetary policy upon them. A simple regression equation relating annual changes in MSCI's emerging markets index to a few variables suggests that monetary policy affects emerging markets through two channels.

One is a change in 10-year Treasury yields: a one percentage point rise in yields, other things equal, is associated with 5.5 percentage points lower emerging markets returns. This could reflect a QE channel; insofar as QE reduces yields, it raises emerging markets share prices as investors rebalance their portfolios towards riskier assets. Or it might indicate a simple expectations effect; bond yields should equal expected short-term interest rates so if markets expect short rates to rise - causing bond yields to rise - emerging markets sell off in anticipation of tighter money.

There's also a direct QE effect. An increase in the Fed's holdings of Treasuries and mortgage-backed securities of $1 trillion over a 12-month period (equivalent to just over $83bn of QE per month) is associated with 17 percentage points higher annual returns on emerging markets.

These two channels imply that QE has big effects, which might imply that with the Fed likely to continue withdrawing QE, emerging markets could suffer a lot more.

Not necessarily, for two reasons. One is that although our simple regression equation can explain over four-fifths of the variation in annual returns on emerging markets since the start of 2002, it has recently over-predicted returns; emerging markets have done worse than our equation predicts. There's an obvious reason why this might be. It could be that investors have dumped emerging markets in anticipation of the Fed reducing QE. Markets should, after all, discount the future. If this is so, then a big cut in QE is already in the price - which means we have little to fear.

Secondly, our equation points to a couple of positives for emerging markets.

One is that they are now cheap. MSCI's emerging markets index, relative to the US, is slightly below its post-1990 average. It's not so low as to point to big, quick rises, but it at least reduces one potential source of downward pressure.

The other is that the Vix index - a measure of implied volatility on US stocks - has risen lately, In the past, this has led to higher emerging markets returns in the following 12 months. This is just what common sense would imply. A high Vix index means investors are scared to take on risk, so investors who do buy risky assets then should be well-rewarded for doing so.

There is, though, a big issue here: what happens to the US market? Controlling for other things, emerging markets since 2002 have had a high beta with respect to the US, rising by almost 13 per cent for each 10 per cent move in US share prices.

The danger here is that we could suffer a negative feedback loop: crises in a few emerging economies lead to worries about US banking losses, which drag down the US market which in turn drives emerging markets even lower.

The more benign possibility is that continued economic growth causes US shares to rise which helps emerging markets. There has for years been a strong correlation between annual changes in industrial production and annual US equity returns, which implies that the 2.9 per cent output growth which economists expect this year should raise equities. And if this doesn't happen, the Fed won't withdraw QE as much as feared, so emerging markets will get some relief on this front.

For what it's worth - which is little - my hunch is that (subject to provisos about overreaction and the wise old warning not to try to catch a falling knife) much of the worst is over for emerging markets in general.

But this is not my point. Instead, the point is that recent events corroborate the view that emerging markets are a bet not so much upon local economic conditions as upon US monetary policy.

The equation

My table summarises the regression equation I've used in the above. I've ran it since 2002 because current data on Fed securities holdings began then.

What I didn't mention above - because it's not relevant at this stage - is that the fed funds rate also affects emerging markets returns in two ways. A high level of the funds rate leads to higher returns. And a rise in the rate is associated with higher returns.

I wouldn't rely upon this for forecasting purposes. I constructed it merely to try and answer the question: what impact has QE had on emerging markets?

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