EM Equities ‘Goldilocks’:It is all about US10Y &DXY

Easing & convergent policies drive EMs but...

It was only 12 months ago that most economists were expecting that by nowUS 10Y bond yields would be approaching 2.5%-3.0% and almost no one wasanticipating that global bond yields would be negative. Today, US10Y bondyields are 1.5% (having recently touched the low of 1.3%) and more than 1/3of sovereign bonds are now yielding negative returns. Similarly, expectationwas that divergence of monetary policies should continue to power US$;instead DXY, having rallied steeply in Dec’15-Jan’16, has remained broadlyflat (down ~5%) since early Feb’16. In our view, it was this combination oflower bond yields; weaker US$ and stronger ￥ that created a ‘Goldilocks’environment for EM equities. YTD, EMs outperformed DMs by ~8-9%, withmost of the outperformance occurring since early Feb’16, with commodity andterms of trade markets (Brazil, Russia, SA and Indonesia) taking the lead.

The transmission mechanism is through liquidity flows and global reflation.

The US 10Y bond yield is the single most important price of money in theworld whilst DXY (US$) is the dominant currency of trade and financialtransactions. Hence cheaper money and lower US$ tend to reflate globaleconomy and trade as well as support the commodities complex. As investorsbecome more confident that cyclicality is improving without incurring cost ordislocation of rising cost of money, EMs pick up momentum and startgenerating a self-perpetuating cycle of lower volatility and stabilizing earnings;essentially a reversal of what investors experienced between 2011 and 2015.