The dovish comments by Fed Chair Janet Yellen on Tuesday have given wings to the U.S. stock market, as Rev Shark remarked after her speech. But one asset class that has been rallying under the radar since the start of the year will benefit the most.
Emerging markets have staged an impressive comeback, after being hammered for a long time. The iShares MSCI Emerging Markets ETF (EEM) is up more than 5% since the beginning of the year, and rose by 1.21% in premarket trading on Wednesday.
In Asia, China's Shanghai Composite finished up a healthy 2.76%, buoyed by Yellen's speech in which she repeated that the central bank needs to "proceed cautiously" on interest rates. This is despite signs that inflation is beginning to stir in the U.S.
Even before Yellen's speech, investors were returning to developing countries' assets. In the week that ended on March 23, inflows into emerging markets debt funds accelerated, according to data analyzed by Bank of America Merrill Lynch.
Emerging market bonds saw their largest inflows since June 2014 in that week, worth $1.4 billion. It was the fifth week of inflows into emerging market debt. Things were positive for emerging market equities too, which saw $3 billion worth of investor money pouring in, the biggest inflows since July 2015.
All this may be encouraging, but investors must still take into account the risks they face. A recent paper published by the International Monetary Fund (IMF) highlights the fact that financial "safety nets" in case of a crisis are more solid in developed markets than they are in developing ones.
These safety nets are made of international reserves, central bank bilateral swap arrangements -- like the Fed had with the major central banks at the height of the financial crisis -- regional financial arrangements, resources from the IMF and market instruments.
They have three aims: to provide insurance for countries against crisis, to supply financing when countries are hit by crises and to incentivize sound macroeconomic policies.
According to the IMF paper, advanced economies have the most adequate safety nets, whereas in emerging markets they are still inadequate and need to be strengthened. The IMF warned that even if countries seem to have good fundamentals, they could still be dragged into a financial crisis.
"Countries with relatively strong fundamentals (innocent bystanders) are not exempted from liquidity shocks, as a rise in global risk aversion can prompt investors to deleverage across the board," the paper said.
This does not mean that investors should not look to diversify by putting money into emerging markets. They should, however, take into account the strength of the economies, and for this the IMF paper is useful because it identifies some elements that investors could look at to judge how vulnerable the countries are.
Reserves are the most important element. They grew to $12 trillion by the end of 2013 from just $2 trillion in 2000, and two thirds of them are held in emerging markets. But reserve coverage varies dramatically between countries, so ideally investors should look to put their money in countries where reserves cover 100% of the countries' short-term debt.
Another element to look for are bilateral swap agreements. These have mushroomed after the financial crisis and can be seen as an extra source of liquidity in times of stress. For example, during the crisis we saw the Fed extending dollar swaps to Brazil, South Korea and Singapore, and the European Central Bank extending euro swaps and/or repurchase agreements with Hungary, Latvia and Poland.
Interestingly, right now the swaps scene is dominated by China: the country had more than 30 renminbi swap lines in place at the end of last year, equivalent to around $500 billion.
Finally, investors should look for regional financial agreements, too, to judge whether the emerging market they want to put their money in is well anchored in case of a crisis. Such an arrangement is the European Stability Mechanism (ESM) in the eurozone, which was set up to lend money for crisis resolution.
In emerging markets, the Chiang Mai Initiative is a regional currency swap arrangement between the 10 members of the Association of Southeast Asian Nations (ASEAN), China (including Hong Kong), Japan and South Korea.
There are other regional initiatives, such as the BRICs multilateral Contingent Reserve Arrangement (CRA), which has resources worth $100 billion to help members meet balance of payments pressures, provide mutual support, and strengthen financial stability in case of crisis.
In the Middle East and Latin America the IMF paper cites the Arab Monetary Fund (AMF) and the Latin American Reserve Fund (FLAR) as regional initiatives.
Interest rates, and therefore yields, seem set to remain lower for longer, as Yellen herself confirmed. Investors will therefore rush to emerging markets again, so it makes sense to turn to the IMF for expertise in what to watch for in order to be protected in case of crisis.
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