As Fed changes to dovish, emerging markets could rally

As the US stocks bull market is now officially the longest after World War II, fears are increasing that the end is nigh for the bulls. However, the approach of the US mid-term elections in November might mean not just that the bull market could continue, but also the end of the emerging markets rout.

It doesn’t look like that for now. The latest data seem to show that investors have “nowhere to hide,” according to the latest analysis of capital flows by Bank of America Merrill Lynch. “Almost all the risk assets we follow recorded outflows last week,” the bank’s analysts wrote.

The so-called trade war certainly has something to do with this. The stocks of companies in Europe, which rely heavily on exports, have been among the hardest hit. For 24 weeks in a row, European equities have seen a total of $56 billion in withdrawals.

For emerging markets, debt was the victim. The magnitude of the outflow from global emerging markets debt funds more than tripled week on week.

It’s fair to say that so far this year, the picture is not encouraging.

Outflows from all asset classes have accelerated.

Outflows from all asset classes have accelerated. Source: Bank of America Merrill Lynch.

Despite this, the Bull & Bear indicator developed by Bank of America Merrill Lynch climbed slightly to 3.3 from a previous level of 3.0. As a reminder, the indicator triggers a “buy” signal once it falls below 2.0, and a “sell” signal once it climbs above 8.0.

Things could get better for markets in general and for emerging markets in particular as the Federal Reserve changes from hawk to dove. Fed Chairman Jerome Powell surprised many observers last Friday with his dovish remarks in his Jackson Hole speech, and global stocks took off.

Powell said that he and his colleagues believed a “gradual process” of raising interest rates was appropriate, whereas in previous speeches he seemed to be suggesting that the Fed would go ahead and raise rates at a steady pace.

President Trump had said before Powell’s Jackson Hole speech that he wasn’t thrilled with the strong dollar and, although the Fed Chair did not refer in any way to the president’s remarks, it is quite likely that he took them into account. Central bank independence is by no means 100% certain.

A strong dollar in the middle of a trade war would not be good for the US economy, because it makes America’s own exports more expensive at a time when China retaliates with its own tariffs. Higher fed funds rates also ultimately lead to tightening credit conditions in the US. If these tighten too rapidly, the US economy could slow dramatically.

None of these outcomes would be good in normal times, let alone at a time when the incumbent President’s party has to fight mid-term elections. President Trump, besieged by accusations of improper conduct and revelations from former associates’ lawsuits, needs any help he can get on the economy front.

With emerging markets still highly dependent on the US dollar’s rate, this can only benefit them. And after the dramatic fall they experienced this year, a rally in emerging market assets would not be terribly surprising.