Why the Fed’s QE taper will be bearish for emerging markets

Market Realist

EM economies are levered to U.S. monetary policy

Many developing economies such as Brazil (EWZ) and Taiwan (EWT) peg their currencies to the U.S. dollar. The reason is to stabilize capital flows into and out of the country, which can benefit economic development. However, when the country whose currency an EM (emerging market) country is pegged to changes its monetary policy, the EM country’s economy is affected. This was a problem in the late 1990s for countries such as Argentina that suffered deflation by pegging their currency to the U.S. dollar as the tech boom sharply increased productivity. The most recent example of currency pegs hurting EM countries was this past summer, when the taper talk drove up market volatility.

 

When a country’s currency is pegged to the U.S., its value as a portfolio diversifier suffers

One of the strongest arguments for international investing is to diversify away from the risk factors driving the U.S. economy. However, the biggest factor driving U.S. stocks right now is monetary policy, so investors looking to diversify away from that by investing in EMs are actually increasing their exposure to the Fed.

The relationship is similar to the Eurozone, where economic differences call for different forms of monetary policy in different countries. While the ECB’s (European Central Bank’s) current stance might be alright for Germany, it definitely isn’t for Greece or Italy. Similarly, even if the Fed waits to taper until the U.S. economy is back to full employment, the timing will probably not be good for EM countries.

Currency pegs mean investors should treat EM countries like high beta sectors in the U.S. You can achieve true international diversification instead by investing in countries that have their own monetary policies, such as Australia (EWA) or the UK (EWU).

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