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).

Image showing total returns of Emerging Markets, US Large Caps and US Small Caps

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:

  1. U.S. policy has been overly easy (negative real rates) while Emerging Market policy has been overly restrictive (positive real rates).
  2. 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.

Table showing Global Central Bank Policy Rates

Second, while U.S. and European inflation have been moving higher…

`Graphs showing US Consumer Price Index and Eurozone Consumer Price Index

Emerging Market inflation has been moving lower…

Images showing Brazil and Russia Consumer Price IndexesImages showing China and India Consumer Price Indexes

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.

Graphs showing ratio of S&P 500 to Emerging Markets and total returns of S&P 500 and Emerging Markets


Related Posts:

When Bond Kings Short Emerging Market Equities

Is the Great Divergence in Central Bank Policy Sustainable?

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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.

You can follow Charlie on twitter here.

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