EM Investor Reactions to Fed’s Decision

Ending months of speculation, the US Federal Reserve decided to hold interest rates at their historic low levels last week, as concerns for a fragile global economy overshadowed recent evidence of a strengthening US recovery.

Janet Yellen, the Fed chair, stressed that growth in emerging markets was an important consideration behind the decision to keep US interest rates on hold. Forecasts from the Fed’s board members had suggested that the first increase in nine years would take place this year, but three officials now expect Yellen to hold off until 2016, and one predicted it may even be 2017 before rates rise.

Institutional investors and analysts have already begun to speculate regarding the impact of the decision on emerging market investment strategies. In today’s blog, we have summarised some of these reactions.

As a refresher, here is an updated emerging market performance/valuation map

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Franklin Templeton:

“In our view as investors in emerging markets, this isn’t necessarily positive news, because we are still left with the uncertainty that has been plaguing the market for some time. We know that the markets dislike uncertainty, so we could also be left with continued volatility through year-end.

On the other side of this equation are the positive aspects. If in coming months the Fed feels confident enough in the US economy to raise interest rates, it could be viewed as positive news for emerging markets, particularly those with export ties that benefit from a strengthening US economy. We would anticipate a stronger US economy would likely bring increased demand for more imported goods, and a stronger US dollar relative to other emerging market currencies could put emerging markets in a more favorable trade position. Weaker currencies tend to promote exports and help manufacturers.”

J.P. Morgan Asset Management

“Regardless of economic impacts, the Fed’s rationale for its decision does suggest a slower general increase in interest rates, limiting bond market losses and potentially producing gains in some areas. It could also boost emerging market assets if investors feel less urgency to move money ahead of a more general flow of capital to the United States. Finally, it could limit U.S. equity market gains. While the Fed cited volatility as one of its reasons for not raising rates at this meeting, increased uncertainty about the Fed will likely increase volatility and thus hurt U.S. stocks even as the Fed itself, satisfied with U.S. progress, nevertheless waits on the world to change.”

Recent related piece from Gabriela Santos Global and Ben Luk from Global Market Strategy team titled Emerging markets and the Fed: A game changer?

Fidelity Management & Research

“The market was not expecting a rate hike, so this outcome is exactly what was priced in. So while there is often a lot of noise immediately following a Fed announcement, there shouldn’t be a lot of market movement in the short term. Long-term, conditions haven’t really changed. The United States remains the best house in a bad neighborhood—domestic economic progress is better than in most other developed countries. With slow growth, a low rate environment may persist for longer than many investors were anticipating. If the Fed does move to tighten in the near term, it’s going to squeeze dollar liquidity even more. In my view, that could potentially be an even bigger headwind for some areas, like China and emerging markets, which have already been hit the hardest. So, my expectation going forward is that the market volatility we’re seeing is going to remain relatively elevated.”

Recent related piece from Dominic Rossi (Global Chief Investment Officer, Equities, at Fidelity Worldwide Investment):  FT: World faces third deflationary wave – EM crisis means further fall in potential global output is unavoidable


“As external factors are outweighing domestic it could be argued that the outlook for the Fed now depends on the outlook for China. In our view China may get a boost from fiscal support in the coming months, but the underlying picture is one of an economy where growth is grinding lower.  The Fed could well wait beyond January before lift-off with March 2016 now the more likely date. All in all, the Fed’s economic outlook remains relatively stable and positive. However, it is clear that international developments will dominate Fed policy in the near-term.”

Deutsche Asset & Wealth Management

“While the Chinese backdrop is not encouraging, the U.S. domestic economy continues to do well and the Eurozone is getting back on its feet, meaning that any developed-market correction is likely to be short-term in nature. Emerging markets may find the going tougher. Aggregate EM economic growth remains strong but there does appear to be an underlying trend towards slower export growth, even after the recent currency depreciation. A structural shift towards consumption in many emerging markets may be one reason for this. Another could be the increasing economic complexity of Asian economies, meaning that they can handle more aspects of the production process internally with less need for foreign trade of inputs.”

UBS Asset Management

“It now looks likely that the Fed will hike in December, despite Chair Yellen’s insistence that the October meeting is still ‘live’. It is often argued that the Fed will only start its rate hikes when it has a press conference to explain, but there are procedures to call an ad hoc press conference after any meeting so that is not really a limitation. What is a limitation is that the “global economic and financial developments” are unlikely to be resolved enough in the next six weeks for the Fed to feel more confident.”

HSBC Asset Management

“EM equities are attractive for western currency based investors (USD, GBP or euro based) in our view. Within EM, Asia is our preferred region, as the prospective returns look higher, supported by the potential for currency upside over the long term, though there could be some volatility in the near term with Fed tightening approaching and a slowdown in China. We continue to believe that the global economic recovery is on track and global equity markets will post positive returns over the long term. In our opinion, continued support from global quantitative easing (QE) will, in the medium and longer term, likely outweigh headwinds created by slower Chinese growth and tighter US monetary policy.”

Lazard Asset Management

“We have taken advantage of the recent volatility to allocate capital to companies that we view as being punished in disproportion to their actual cash flow at risk. Having deep bottom-up fundamental research and clearly defined scenarios for company earnings and valuation can turn situations like these into excellent buying opportunities.

The China slowdown is to some degree inevitable as the law of large numbers and competitive pressures arising from wage increases and environmental degradation affect growth. Many companies have adapted to a range of economic changes in the last decade and will do so in this situation. Valuations are not stretched, especially after the recent sell-off, although they are above historical levels. When compared to fixed income alternatives, equities look inexpensive on many counts. Our view is that the near-panic seen in recent days in various markets could represent a capitulation that creates opportunities for investors with time horizons measured in years rather than months.”


Julius Baer

“The question for investors and emerging markets (EM) is not whether the Fed is going to hike rates or not. The question over the next 12 months is whether there will be negative surprises (more hikes than expected) and which emerging markets are the most vulnerable.”

State Street Global Advisors

“Resolution of China’s debt woes and a growth trough are likely to be a bigger drag than near-term fed action. While the situation today is reminiscent of the fed hike in 1994 and subsequent EM crisis, it’s important to note that the current debt in EM’s is predominantly in local currency and FX reserves still remain strong.”

Sources: Public statements, documents and websites of relevant companies. Chart is sourced from Blackrock Investment Institute.

Long March Forward

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The Saudi Capital Market Authority, under new leadership, has announced that qualified foreign institutions will have access to the Tadawul stock exchange from 15 June 2015 with the final rules to be revealed on 4 May. This comes as no surprise, given the announcement in July 2014 of plans to allow direct foreign purchases of shares in the first half of 2015.

But why does opening up the Saudi equity market matter? What could be some of the macroeconomic effects? With Saudi and other  oil exporters facing an oil price tsunami, economic policy should be directed at mitigating the negative consequences. The IMF estimates that there will be a massive loss of $380 billion in exports, equivalent to a 21 per cent hit to GDP. The expectation is that opening up the market will attract foreign capital that previously did not have access to Saudi investment opportunities. The capital inflow, in theory, could lead to increased investment in promising sectors, bring in new technology, boost IPOs, galvanise mergers & acquisitions and improve corporate governance all of which would translate into greater economic diversification and job creation, the overarching economic policy concern. The underlying risk is that asset prices get bid up, a bubble forms, Saudi investors sell and real invest does not happen.


Opening of the market comes as part of a continuing policy of opening up, economic liberalisation and gradual international integration that  has been pursued  over the past  10 years. Saudi Arabia has been successful in upgrading infrastructure, strengthening education  and skills, boosting  access  to finance for SMEs, and significantly improving the business environment. Substantial progress has been made on lowering the cost of doing business  over the years. Saudi Arabia is today the only Middle East country and only OPEC member among the constituents of the G20. It joined the WTO in 2005 (which included clauses  like allowing 60 per cent foreign ownership in banking and insurance, and 75 per cent foreign ownership of distribution  within three  years). Saudi built  economic cities and industrial zones to move away from its over-dependence on oil. But oil still accounts  for about 92 per cent of government  revenues  and though the share of non-oil real GDP has increased over the past  two decades, non-oil sector exports remain limited. Foreign investment can support economic diversification.


The conservative Saudi capital market regulator had initiated several  steps to liberalise the market  over the last  few years, including aligning working days with other  GCC and international markets with Tadawul opening on Thursdays, and improving corporate governance standards to make the Saudi market attractive to foreign investors. Draft market  access  rules, shared  in August 2014, included a 10 per cent cap on foreign ownership of the market’s value and that  a single foreign investor could own no more than five per cent of any listed firm, while all foreign institutions combined could own no more than 20 per cent. If this limit is confirmed then the promised  Saudi overture  might prove to be too timid, a damp squib.

The Saudi and other GCC stock markets are massively dominated by retail investors. Retail investors currently account for more than 90 per cent of the share trading volume of the Tadawul, while foreign investors have been restricted to buying Saudi shares  indirectly through swaps or exchange- traded funds. But retail investors may be prone to fickleness and bouts of irrational exuberance leading to volatility. Institutional investors  such as pension funds, insurance companies, and investment funds are less likely to be prone to animal spirits, or so it is hoped. Increasing the share of institutional investors should help stabilise markets.

Opening of Saudi capital markets has been proceeding in phases, initially opening up to GCC investors, then opening to investment funds and now opening to qualified foreign investors.The opening up provides foreign investors access to the largest economy and



capital market in the Middle East. Saudi Arabia is the largest economy in the Middle East, with a nominal GDP of $752 billion in 2014. Tadawul has over 160 stocks, a market capitalisation of approximately $530billion and relatively more diversified compared to other exchanges in the region, with sector representation from petrochemicals, banking, telecom companies, retail and real estate. The chart below, shows the market capitalisation and turnover of the GCC markets, underscores the importance of the Saudi market: Tadawul alone accounts for more than 50 per cent of the market cap of the GCC countries and is the most liquid.


Saudi’s ouverture finally allows foreign investors to diversify risk and gain exposure  to GCC investment opportunities through UAE, Qatar and now Saudi markets. Indeed, it is only in the past  year (May 2014) that  both UAE and Qatar were reclassified from Frontier to Emerging Market Status by the MSCI. MSCI considers  both size and liquidity requirements and market  accessibility  for its country classification  into Frontier or Emerging. The former are based on the minimum investability  requirements while the latter are based  on qualitative measurements that reflect international investors’ experience in investing in a given market, including laws, rules and regulations that provide for investor protection.

Will Saudi Arabia go through this process of a reclassification as well? According to MSCI, based purely on the existing size of the Saudi market, Saudi Arabia would have an equivalent weight of about 63 per cent in the MSCI Frontier Markets index, and about four per cent in MSCI Emerging Markets – the inclusion would attract passive foreign institutional  investors  or index investors that would have to rebalance their portfolios to include Saudi. The index house has already stated that a market does not necessarily need to pass through frontier status before entering the Emerging Markets universe. The earliest Saudi Arabia could officially enter either the frontier market or emerging market (more likely) would be mid-2017 considering the usual timelines for the evaluation and consultative process. Saudi Arabia, at present, has a standalone classification from S&P.


What can Saudi Arabia look forward to with the opening up of its capital markets and subsequent foreign investment? Opening the stock market is only one step in what ought to be a Saudi financial markets development strategy. Efficient financial markets require breadth (a wide variety of financial securities and instruments), depth (sufficient size to enable transactions without leading to large bid-ask spreads) and liquidity (ability to enter and exit markets without affecting price).

Saudi needs active money markets, bond and Sukuk markets, and a mortgage market  for housing finance. Saudi Arabia should however use the opening up of its capital markets to encourage more listings of both Saudi and GCC companies (dual listings). The exchange is largely dominated by energy-related companies and financial firms. It is necessary to reduce the high concentration of capitalisation in a limited number of stocks: for example, the top FIVE names (including SABIC and Al Rajhi Bank) account for more than one-third of Tadawul. Developing the financial markets should also be part of a strategy of economic diversification, via attracting capital into promising sectors such as tourism and hospitality, transport, education, health, services etc. but the time is also opportune to start a programme of privatisation e.g. Saudi Airlines and greater PPP in infrastructure and logistics.


The ouverture of Tadawul should be part of the equivalent of a Chinese ‘Long March Forward’ of a continuing modernisation and reform strategy and of greater regional and international economic integration. The move should be a harbinger of further reform providing wider market access and establishment of foreign companies and persons via deep legal and regulatory reforms,public private partnerships,and privatisation and labour market reforms to create a dynamic,vibrant economy able to create jobs for generations of young Saudis, both women and men. But why stop there?

As the region’s biggest economy, Saudi can and should be the region’s engine of growth. Given Saudi’s massive wealth and being a major capital exporter, the Saudi market should be open to foreign listings (including government and corporate bonds and Sukuk) and cross-listing from the other GCC and Arab markets. An example would be allowing Egyptian companies  and government  to list equity, bonds and Sukuk that  would help finance Egypt’s infrastructure, inclusive economic growth and development.  Finance and trade are better than aid! Saudi’s Tadawul should move away from being insular and inward–looking to become a regional market helping finance economic growth and development across the Arab world and wider region.

This is a guest blog post by Dr Nasser Saidi. It originally appeared in CPI Financial