We have been consistently negative about the prospects for emerging market debt and equities for the last six months and were in print on the subject at the beginning of this month (Emerging Markets – Not Yet, 9th January 2014). Not surprisingly these two asset classes are at the bottom of the ranking in all our asset allocation models following last week’s sell-off. It’s nice to be right, but we don’t think the price action is telling us about some deep-rooted structural flaw in the global financial system.

For the time being, we regard this as a simple case of Fed tightening leading to a stronger trade-weighted dollar, and a decline in emerging market equities. The FT did a very good piece today highlighting just how powerful this relationship has been over the last 20 years. Assuming that the Fed carries on with the taper, we should expect further pressure on EM currencies, and for the impact to spread beyond emerging markets. What follows is not an exhaustive list of what will happen next, just a round-up of some of the developments we see in this week’s reports, which were based on last Friday’s close.

1) The Eurozone periphery has the same twin deficit problems that many emerging markets suffer from. Remember that Greece is already classified as an emerging equity market and that Spanish banks have significant exposure to Latin America (though not much to Argentina). The creditworthiness of Spanish banks and their host government is still closely entwined. Our Eurozone sovereign bond model has already begun to reduce its exposure to Greek and Spanish bonds.

2) The emerging market sell-off has already impacted the equity markets of Japan and developed Asia-Pacific. We expect Japan to press on with the devaluation of the yen against the dollar, but the government may be tempted to start sooner than the end of the financial year in March. There may soon be an opportunity to repeat the short yen / long Nikkei trade that investors enjoyed so much in Q1 2013.

3) Repatriation of US dollars implies that Treasury yields will be better supported than many bond bears thought, and that the spreads on investment grade and high yield bonds can contract further. This is consistent with the increase in our holdings of these assets this week.

4) The implications for US equities are complicated because the earnings season suggests that forecasts for 2014 will have to be revised down. Our model shows that US investors have subtly altered their stance on investing for growth, moving towards the secular sectors such as Tech and Health and away from the purely cyclical such as Consumer Discretionary and Financials. There is still no evidence of a general rotation into defensive sectors such as Utilities or Consumer Staples.

The risk to this analysis is China. If the shadow banking system is a catastrophe waiting to happen (like Japan in 1989) the impact on Chinese capital investment and global commodity prices will be much worse than we expect. We don’t yet know how bad this problem is, but we are not sure that anyone else does either.

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