The overriding impression over the past few years, that investors have taken flight from developed markets and poured money into emerging market (EM) funds instead, is actually a mirage. In fact, according to research by Ulrich Volz for the German Development Institute (DIE), the flow of capital in new markets has actually been falling since reaching an absolute peak of $1.2 trillion in 2007, and each successive wave of capital has never quite matched the year before. The total inflow for 2013 was forecast to fall to $800bn, but that was before the current turbulence in India and Indonesia shook the currency markets. Coincidently, this closely mirrors the weak performance of the MSCI emerging markets index over the same time period.
Pulling power...
In economics jargon, what currency and emerging markets are experiencing is the power of the "pull factor", which explains how capital and investment is drawn in, as opposed to the "push" factors that send money into economies. The Federal Reserve's loose macroeconomic policy clearly had a major influence in driving the "push" into new economies in recent years, although seasoned investors will know that the link between underlying economic growth and eventual stock market performance is not as clear cut as you would first think.
Now that monetary policy looks to be tightening, even local investors in emerging markets realise that it is sensible to buy US dollars, which is why currencies across Asia have been falling. The results are dramatic and the DIE's research suggests that every 23 basis move on dollar-denominated debt yields can lead to a 2 per cent rise or fall in currencies across the developing world; the yield on US 10-year Treasuries has risen by a full percentage point in under three months to 2.9 per cent, suggesting that currencies like the Indonesian Rupiah or the Korean Won will continue to devalue for a while yet. Interestingly, this also reflects a more sober narrative of emerging market growth that has emerged this year, with increasing evidence that the low-cost labour model in countries like China is starting to founder on the rocks of major demographic changes, alongside the infrastructure problems and energy scarcity that traditionally places a cap on EM growth.
The other pull factor is that developed countries are starting to emerge from recession with their banks, better capitalised and a labour force that is looking more cost-competitive than at any time in the past decade. Taken together with the energy revolution in the US, where manufacturers' energy costs have fallen by 75 per cent, and you have a very powerful set of "pull" factors drawing investors' money northwards into US dollars, sterling and euros.
Chris Dillow is currently on annual leave.
