Taper Tantrum

John Authers at the FT had a great video on when to Buy BRICs this week.


Given how all the research presented showed that Emerging Markets are very cheap relative to Developed Markets, it was surprising to see Andrew Pease sitting so firmly on the fence. No wonder people have such a dim view of consultants these days.

I did, however, take some comfort from him being as wrong as I was with regards to the onset of Fed Tapering; I was convinced it would not start until q1 2014.

Given the strength of US GDP revisions on Friday, in hindsight it is clear why the Fed moved when it did. Having said recently that I expect GDP estimates to get revised up in both the UK and the US in early-mid 2014, I confess I am now a little thrown that we are seeing that so soon.

Both inflation and unemployment remain below the Fed's targets, which is why the Fed has made it so clear that they do not intend to raise rates anytime soon. If, however,  GDP growth is going to surprise on the upside quite so dramatically, then QE will be withdrawn much faster than I am currently anticipating and the Fed will be forced to reconsider its rate stance. This is the biggest visible threat to my base case scenario, and with it the risk of a "melt up" in Emerging Markets.

If the risk is increasingly that of a "Melt up", the risk is not that higher interest rates depress EM valuations, but that the stronger growth in the US, UK, and Germany drags up EM earnings estimates. Merrill recently published an excellent piece outlining their thoughts for next year in Emerging Markets. They point out that bottom up earnings expectations for EMs are usually too high at the start of the year, and they generally fall as the year progresses. Expectations for 2014 are unusually low on this basis, whilst the economic outlook appears to have upside surprises.

Is this the year analysts start too pessimistic?

As the FT makes clear, we have seen massive redemptions from retail investors out of Emerging Market Bond funds ahead of Fed tapering, whilst I had previously posted a video from an RBC Portfolio Manager showing how there had been a lot of late selling by Hedge Funds who had been weak holders of EM debt. Long-term Institutional money had basically sat still. To me this says that institutions are now more firmly committed to EM markets, both debt and equity. During the Asian crisis the question was often if institutions should hold EM Assets, whilst now it is more a question how much they should hold. Andrew Pease's fence sitting was therefore more appropriate for the old way of thinking, whilst  I would advocate a bolder stance more fitting to the "modern' thinking; buy the cheap assets, but put on a hedge if you are nervous. I believe we are now at the "sell on the rumour, buy on the news" stage. The cheap parts of EM equities are now very cheap according to Merrill, with a lot of bad news built into the price; How much cheaper can they get, barring a crisis? You just need to pick the right stocks.