“After years of targeting inflation, central banks are facing a new paradigm in conducting monetary policy. It will force some of them to choose between strictly meeting their inflation targets and safeguarding financial stability.
“The US Federal Reserve (Fed) is anxious about financial stability because excessive asset valuations are often linked to increased risk appetite, leading to more risk-taking and leverage. In turn, that increases the vulnerability of financial markets. If valuations were to fall, leveraged equity investors may face significant losses, which could cause contagion to other markets.
“So despite low inflation in the US, the Fed continues to signal that further increases in the policy rate will be needed in the near future. Raising the cost of borrowing would help prevent some of the leveraging that high valuations and increased risk-taking lead to, ultimately reducing the risk being baked into the system.”
Emerging markets are more resistant to developed market monetary policies
“For emerging markets however, we believe that the modest reduction in monetary stimulus in the developed world is unlikely to have a major impact on emerging markets as the continued improvement in economic fundamentals will continue to support equities.
“Moreover, emerging equity markets have changed fundamentally in recent years. They used to be heavily influenced by the commodity cycle, but the share of commodity-linked equity in emerging equity indices has declined in recent years relative to other sectors. As a result, emerging equity markets appear more resilient as a result of the falling beta to commodity prices. Simply put, EM equities no longer require an increase in commodity prices to outperform and rely more today to structural improvement making them more domestic demand driven. As such, we remain bullish on emerging equity but we continue to closely monitor the current shift in bond market dynamics.
“We also see a favourable outlook for EM bonds in local currencies, as the positive fundamentals driving equities are also supportive of local bonds. In addition, we think that EM currencies remain undervalued. This could be corrected in the near future, as market participants catch up with the improving fundamentals in the region.”
Salman Ahmed, chief investment strategist at Lombard Odier Investment Managers