Emerging market investors can take only cold comfort from Fed

The Federal Reserve has done it again. The US central bank’s abandonment this week of an earlier projection that it would raise rates twice more this year has left investors “inspired by the knowledge that cheap money is here to stay. Yet the comfort that fund managers can take from believing that the Fed has their back may not be what it once was. For emerging market investors in particular, the prospect of a Fed more minded to cut rates, with the consequent pressure on the US dollar, is not always unalloyed good news. Not only are such dovish surprises from the Fed carrying less weight, they are also likely to be less frequent. You only need to look at last year for a reminder of the influence the Fed can wield over emerging markets.

The year started with a rally, helped by a strong consensus among investors that the US dollar would weaken. When that proved misplaced, EM assets suffered their deepest sell-off since the taper tantrum of 2013. Itself triggered by the Fed’s announcement that it would begin cutting its bond-buying.

When dollar strength then peaked in the fourth quarter of last year, EM assets rallied. Investors began 2019 in better spirits, and January’s sharp rally reflected confidence that the Fed would hold off from raising rates, as trade tensions between the US and China appeared to recede. Yet that buoyant start to the year has run out of steam.Between 2010 and 2018, which included years of very heavy quantitative easing, there were few surprises: both flows and, less consistently, valuations contributed to a huge build-up by foreigners of holdings of the equities and bonds of EM’s. The Fed could, of course, change its view again. But if it does hold steady for the rest of the year, the key forces will be the US-China trade dispute and the broader outlook for the Chinese economy. The outcome of the talks between Washington and Beijing remains hard to predict.