Much has been said about the low level of bond yields in western economies, but one point has been underappreciated – that such low yields should worry investors in emerging markets.
My chart shows the point. It shows how just three factors have explained four-fifths of the large variation in annual changes in MSCI’s emerging markets index this century.
One factor, as you’d expect, is the US stock market. Controlling for other things, emerging markets tend to rise and fall one-for-one with US equities. In this sense, they are not a high-beta asset.
Secondly, there’s the US dollar. Rises in its trade-weighted index are associated with falls in emerging markets, with a 10 per cent rise in the dollar associated with a 16 per cent drop in emerging markets, other things being equal. A strong dollar hurts emerging markets in at least two ways. One is that it raises the cost of imported raw materials and so threatens to raise inflation and hence interest rates. Another is that some emerging market governments and countries borrow in dollars and so a stronger dollar raises the cost of servicing debt.
Our third factor is the yield on 10-year US Treasury bonds. These matter for emerging markets in two ways.
One is that falls in yields are associated with falls in emerging markets. This is an example of correlation not being causality. Falling bond yields are a sign that investors are becoming more pessimistic about economic growth and/or more reluctant to take on risk. When this happens, they dump risky assets, which hits emerging markets especially badly. A percentage point fall in yields is associated with emerging markets falling by 7.6 per cent, even controlling for US equities.
What’s more, though, is that (controlling for other things) low yields predict low returns on emerging markets.
This is probably another yield curve story. Low US yields tell us that bond investors expect short-term interest rates to fall, which means they expect the economy to do badly. And a weak US economy is bad for emerging markets.
You might ask: if bond markets can price in a weak economy in advance, why can’t emerging market equities?
Of course, it’s not just emerging markets that don’t do so. US stocks don't either: an inverted yield curve leads to worse returns on US stocks than does an upward-sloping one.
I suspect the reason for this lies in what Harvard University’s Matthew Rabin has called the projection bias. We project our current tastes into the future and fail to see that they will change: this is why people pay more for open-top cars or for houses with swimming pools in the summer than in the winter. Even if investors anticipate bad times and price in lower earnings, they don’t therefore anticipate that their appetite for risk will fall. The upshot is that shares fall as the full impact of a weak economy dawns on them.
Low bond yields, then, are a warning sign for emerging market investors.
And they are not the only such sign. As I write, the MSCI index of them is slightly below its 10-month average. In the past, it has paid well to sell when this has been the case, because emerging markets are prone to momentum effects. And one good lead indicator for the Chinese economy – growth in the country’s stock of narrow money – is still weak, albeit not quite as weak as earlier this year.
Of course, these signals won’t stop emerging markets rising if the US market continues to rise; if the dollar falls; or if investors recover their appetite for risk. But they are good reasons for caution.
You might object that, given the large number of unknowns, this framework doesn’t do much to tell us where emerging markets are heading. We can often explain without predicting – which might be just what I’m doing here.
Maybe. But there is a big and useful message here. All this reminds us that emerging markets are a highly cyclical asset. They do better than most stocks when the world economy is doing well and appetite for risk is rising (that is, when bond yields are rising) and do terribly in bad times, when yields are falling. This is why emerging markets have for years been hugely correlated with mining stocks.
The question for anybody thinking of buying emerging markets, therefore, is: do I want to load up now with extra exposure to global cyclical risk? Of course, when this risk pays off it does so in big style. Personally, though, I think it takes a braver investor than me to take on such risk now.
