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QE and EM

By Benjamin Shepherd on January 10, 2013

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The inevitable end of the US Federal Reserve’s quantitative easing (QE) will surely create volatility in the markets both in the US and abroad. But thanks to the “virtuous cycle” of capital inflows and national investment that QE has already generated around the world, its demise won’t be a signal to abandon emerging markets.

For nearly five years, it’s been an article of faith that the Fed would support the US economy for as long as it takes to get back to prerecession growth levels. That’s why when the Fed minutes released last week revealed that several members of the Federal Open Market Committee believes that the central bank should halt its bond purchases before the end of 2013, the S&P 500 shaved ten points in two hours.

If the market reacted that strongly just to the discussion of ending QE, imagine how it will greet its actual end. I look for the Fed to end QE sometime this year, despite the fact that I seriously doubt unemployment will reach its target level of 6.5 percent. So far, QE has proven more an exercise in psychology than actual stimulus.

The idea of QE is to increase liquidity and spur credit growth. The thinking goes that if the banks are awash in cheap capital, they’ll lend it out at attractive rates, thereby kick starting the economy but still making profits. But over the past few years we’ve only seen marginal growth in bank lending, according to data from the Federal Deposit Insurance Corporation.

Despite the cheap capital, banks are still gun shy and—rightfully—only lending to borrowers with strong credit profiles. Who can blame them? The banking industry is still being castigated for its role in the financial crisis and paying financial penalties for the bad mortgage-backed bonds it helped to package. But all of that cheap capital isn’t just sitting on bank balance sheets.

Data from the Institute of International Finance shows that more than $1 trillion flowed into emerging markets last year. Nearly $500 billion of that total found its way into Asian markets, about $300 billion flowed into Latin America and about $100 billion was sunk into Africa and the Middle East. Much of the rest flowed into emerging European economies.

And that’s not the end of the capital tsunami; $1.1 trillion is expected to flow into the emerging markets this year.

While emerging markets have been a popular investment destination for decades now—especially the “BRIC” quartet of Brazil, Russia, India and China—most of these massive investment flows can be attributed to the aggressive easing actions taken by the US Federal Reserve, the European Central Bank and even the Banks of England and Japan.

It’s a simple fact of financial life that money is always in search of the greatest potential return and when growth is slow and interest rates are nil in the developed markets, the emerging ones look pretty good.

So with little of the Fed’s cheap capital staying here in the US, the employment situation steadily improving and our housing market on the upswing, I wouldn’t be surprised to see the spigot cut off by the middle of this year. And while the market may react negatively, it’s fair to ask how the emerging markets might be impacted considering they’ve been realizing an economic advantage from all of the cheap capital.

Most of the top-performing stock markets in 2012 were in the emerging markets, with countries such as Venezuela (up 304 percent) and Egypt (up 58.7 percent) topping the boards. Granted, they had the advantage of being among the bottom performers in 2011, but it underscores the point that hot money will go anywhere since a lot of the returns were driven by new capital. The more familiar market of India was also a top performer, gaining better than 25 percent on the year.

From a fixed-income perspective, the emerging markets were also the biggest winners in 2012 thanks to QE. As investors sought out yield wherever it could be found, they scooped up foreign sovereign bonds with such verve and vigor that borrowing costs for governments around the world have plunged.

In Turkey, where inflation remains a concern and the conflict in Syria to its south is occasionally spilling over Turkish borders, borrowing costs have touched a record low. Last year, the country sold 10-year bonds at a rate of just 3.473 percent, less than half the yield fetched the prior year. Turkey also saw its credit rating upgraded to investment grade.

Mexico has also seen its borrowing costs plunge, selling 30-year bonds at a yield of just 4.19 percent. In addition to being a record low, it was just 110 basis points above comparable US Treasuries at the time.
All of that is thanks to QE. But I don’t think the withdrawal of easy money will necessarily lead to a crash in the emerging markets.

Thanks to all of that hot money, Mexico has been able to invest heavily in its transportation infrastructure over the past two years. As labor costs in China have risen and manufacturing jobs are finding their way back to the Western hemisphere, Mexico is beginning to experience another industrial revolution.

But a lack of good roads, a crumbling rail network and constrained port capacity have all been stumbling blocks for many manufacturers looking to relocate. Thanks to its plunging borrowing costs, the Mexican government is finally in a position to address those concerns. Infrastructure investment in Mexico is well on its way to tripling over the next five years, setting up the country for even stronger economic growth down the road. The same basic case can be made for any number of other emerging market countries.

So while the end of QE will likely slow the flow of money into the emerging markets, it has already allowed them to lay the groundwork for a much more prosperous future over the long term. At the same time, I doubt much of the money that’s already found its way abroad will be repatriated thanks to the much more rapid growth to be found in the emerging world.

The US is well past the days when it could consistently deliver gross domestic product growth significantly above 3 percent annually, a condition suffered by much of the rest of the developed world. However, countries such as China can still break 8 percent, and Mexico and Brazil can break 6 percent.

Meanwhile, the sky is the limit in other regions such as Africa, thanks to massive development potential. That’s why some of the greatest investment opportunities continue to lie in emerging markets.

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