The Search for Yield and Emerging Markets

Mon, Aug 22, 2016 - 8:52am

The global search for yield – not an improvement in EM fundamentals – is what has been driving the EM rally this year.

Having turned dovish in February, the Fed has enticed investors to sell US dollars and pile into commodities and risk assets. This phenomenon escalated following the late June Brexit vote. The uncertainties over Brexit and global deflationary pressures led investors to conclude that the Fed would be unlikely to tighten policy meaningfully anytime soon. As a result, the search for yield has gone exponential and flows into EM have skyrocketed.

There is a limit to how far financial demand can propel commodities prices and EM risk assets in the absence of stronger final demand and corporate profits. If final demand disappoints, commodity prices will roll over and drive EM risk assets lower. The chart above demonstrates that there is still a very high correlation between EM share prices and industrial metals prices.

Bottom Line: The global search for yield has driven EM risk assets higher amid lingering poor fundamentals. Our EM strategists believe investors will eventually re-focus on EM macro fundamentals and corporate profits. Once this happens, it will produce a major reversal in EM risk assets: share prices, currencies, and high-risk bonds.

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Tyler Kling: Bull Market Hinges on These Two Sectors

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