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).
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.
Second, while U.S. and European inflation have been moving higher…
Emerging Market inflation has been moving lower…
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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This writing is for informational purposes only. It does not constitute an offer to sell, a solicitation to buy, or a recommendation regarding any securities transaction. It also does not offer to provide advisory or other services by Pension Partners, LLC in any jurisdiction in which such offer, solicitation, purchase or sale would be unlawful under the securities laws of such jurisdiction. The information contained in this writing should not be construed as financial or investment advice on any subject matter. Pension Partners, LLC expressly disclaims all liability in respect to actions taken based on any or all of the information on this writing.
Charlie Bilello is the Director of Research at Pension Partners, LLC, an investment advisor that manages mutual funds and separate accounts. He is the co-author of four award-winning research papers on market anomalies and investing. Mr. Bilello is responsible for strategy development, investment research and communicating the firm’s investment themes and portfolio positioning to clients. Prior to joining Pension Partners, he was the Managing Member of Momentum Global Advisors. He previously held positions as a Credit, Equity and Hedge Fund Analyst at billion dollar alternative investment firms.
Mr. Bilello holds a J.D. and M.B.A. in Finance and Accounting from Fordham University. He has done a B.A. in Economics from Binghamton University. He is a Chartered Market Technician (CMT) and a Member of the Market Technicians Association. Mr. Bilello also holds the Certified Public Accountant (CPA) certificate.
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