Carry trade is the key as emerging markets rally

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Investors became cautious towards the end of last week after the recent record-breaking run on global equity markets. During Thursday’s trading session, the JSE all share index set a new record high of 49 886, nearly 19 percent up on the same date the previous year. This came after the Dow Jones industrial index hit its third consecutive record close of 16 715 on Tuesday.

But thereafter US stocks ran out of steam and markets globally were flat and mixed by Friday. The day’s pullback saw the JSE all share close at 49 159.77. However, the local bourse is still well up on the 46 256 seen at the end of last year and more than 18 percent higher than a year earlier.

The improvement is all down to the renewed popularity of emerging market shares.

David Stockman, on the website Contra Corner, said the benchmark MSCI emerging market index was recording a 7 percent return in dollars, compared with just 1 percent in developed markets.

He said this development was down to the carry trade – the practice of borrowing at relatively low interest rates and investing in high-yielding currencies, in developing economies.

He noted: “It hasn’t taken long for the rebound to flow through to stock markets. In local currency terms, an investor with an equally weighted allocation to each of the equity of the fragile five – Brazil, India, Indonesia, Turkey and South Africa – will already have seen his portfolio regain its previous high reached in May 2013.”

The carry trade buoyed the rand when developed economies slashed interest rates and flooded their markets with money, after the 2008/09 recession. But when the US Federal Reserve announced in May last year that it would end quantitative easing (QE) – a cheap money policy – the carry trade shrank.

And when the Fed started tapering QE, in January, capital washed out of emerging markets, with the rand among the worst casualties. Bloomberg’s index of 20 major emerging market currencies fell 3 percent in January, in the worst start to a year since 2009.

Since then emerging market currencies had seen the longest rally since 2009, Bloomberg said last week.

The change in sentiment came as the markets’ views on US monetary policy “matured”, according to independent economist Cees Bruggemans. This year the US Fed has been systematically mopping up liquidity at home, after five years of easy money, pushing US rates higher.

“But, the consequences after all didn’t turn out to be dire,” said Bruggemans. He noted there had not been “a continuous fast run-up in yields and the dollar. Instead, the whole transitioning remained incredibly benign”.

Stockman noted that the greater the sell-off a country suffered last year, the stronger the rally it had enjoyed this year.

“The fragile five , the markets most reliant on foreign capital and so most vulnerable last year, are no longer looking quite so fragile.”

The rand is a case in point.

“After a 30-month streak of non-stop weakening between mid-2011 and early 2014, taking the rand from near R7 to R11.40 (a 60 percent move), the early months of 2014 witnessed a pullback or correction, reaching R10.35,” Bruggemans said.

But the economic backdrop is gloomy. Manufacturing rose only 0.7 percent year on year in March, while mining production shrank 4.7 percent. Retail sales that month were up only 1 percent year on year. And unemployment climbed to 25.2 percent in the first quarter from 24.1 percent the previous quarter.

Annabel Bishop, the chief economist at the Investec group, warned: “Growth in gross domestic product is at risk of approaching the 1 percent mark this year after 1.9 percent last year, 2.5 percent in 2012 and 3.6 percent in 2011.”

She also noted the destructive impact of supply disruptions on the platinum mines, during a strike now in its 17th week.

The disappointing data and the disturbing scenario on the mines may stave off further interest rate hikes. Old Mutual Wealth’s Dave Mohr commented: “Interest-rate sensitive shares, such as banks, have rallied as the market has toned down its expectations for further rate hikes.”

The Reserve Bank’s monetary policy committee will decide this week whether to leave its repo rate at 5.5 percent or hike by 50 basis points for the second time.

But local data and local policy moves may have less impact on the market than global events. Much will depend on the unreliable carry trade.


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