While fluctuating quantitative easing has clearly been a factor in EM performance over the past year, we do not see Fed behavior as the sole determinant; it is but one of three key forces working together that jointly “explain the pain” in EMs: economic policy and growth in China, individual country developments, and global capital flows. Combined, these events were a perfect storm that swept across EMs and depressed their markets. The Chinese leadership’s decision to cool its economic growth was especially negative for EM countries with resource-based economies and for the Materials sector, which also underperformed as evidenced by the reduction in its weight in the MSCI Emerging Markets Index from one-third to one-fifth. EM country-specific economic issues, politics, and policy missteps hurt investor confidence in the sustainability of GDP growth and corporate earnings. And finally, on an international level, pressure came from a reversal of capital flows from EMs to DMs that contributed to the depreciation of many EM currencies.
Market participants have focused on the volatility created by both the Fed’s notice of withdrawal of its extraordinary monetary stimulus (the “tapering” announcement in May) and then its subsequent about-face on ending Quantitative Easing while economic data remains anemic. But what has been much less appreciated, at least in the media and investment punditry that crosses our desks, is the fact that certain key long-term buyers of US Treasury securities have already been “tapering” their purchases for many months. That group is the collection of foreign central banks in developing countries that for years have been coping with sustained and large investment flows into their economies (both via public markets and by corporate direct investments) by standing in the middle of those transactions, building reserves of US dollars and other foreign currencies, and injecting the money flows into their economies without allowing their exchange rates to adjust fully to reflect the sustained demand for the currency.
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