An Emerging Divergence In Central Bank Policy
We’re closing out the first quarter and Emerging Markets are leading equities higher, with the MSCI Emerging Markets ETF (EEM) up 13.40% versus 4.95% for U.S. large caps (SPY) and 0.18% for U.S. small caps (IWM).
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After many years of lagging returns in Emerging Markets, this is a notable gap. The possible explanation? I wrote of some of the tailwinds for Emerging Markets in a post last year: relatively cheap valuations with improving credit, improving currencies, and negative sentiment. All of these factors have been helpful in driving Emerging Markets up more than 40% from their lows.
Today I want to highlight an additional positive factor that I have been tweeting about in recent months: a divergence in central bank policy.
For a number of years, the developed world was maintaining a very easy monetary policy while most Emerging Market countries were tightening. Faced with currency depreciation and higher inflation, they had little choice in doing so.
Over the past year, that backdrop has changed. While the U.S. has hiked rates, India, Russia and Brazil have eased. The impetus for these moves are twofold:
- U.S. policy has been overly easy (negative real rates) while Emerging Market policy has been overly restrictive (positive real rates).
- U.S. inflation has been moving higher while Emerging Market inflation has been moving lower.
Let’s run through a few charts to illustrate.
First, you’ll note in the table below that most of the developed central banks are maintaining negative real interest rates while most of the emerging world have positive real rates.
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Second, while U.S. and European inflation have been moving higher…
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Emerging Market inflation has been moving lower…
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The improving inflation picture and increased ability to ease has been a tailwind for Emerging Markets over the past year. Will that continue? I don’t know, but with real interest rates still positive by a good margin, they still appear to be in a better position than the developed world.
And with U.S. equities outperforming Emerging Markets by more than 100% in the past seven years, the opportunity for mean reversion remains.
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Disclaimer: At Pension Partners, we use Bonds as our defensive position in our absolute return strategies for all of the above reasons. Bonds have provided a more ...
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