A tide of money went out to emerging markets for more than a decade, pushed by accommodative monetary policy in the U.S. and pulled by the promise of robust growth.
Now that tide is coming back in as investors seek to repatriate funds or flock to U.S.-dollar denominated assets as a safe haven amid sluggish economic growth and global market turmoil.
"There are around 47 trillion dollars in private and official investment abroad and far too many that wish to retreat home or to the U.S.," writes Deutsche Bank Macro Strategist Sebastien Galy in a report titled "The Retreat of Global Balance Sheets." "These flows are triggered in good part by a recognition that emerging markets' potential growth is slowing down structurally without enough compensating growth in developed economies."
The broad implications of this is that liquidity will be starved in parts of the emerging markets but ample in advanced economies and that the U.S. dollar and euro should benefit, the latter more so from direct investments than from portfolio inflows.
In some respects, emerging markets have become victims of their own success, notes Galy, who explains how we reached this point:
Growth is easier initially in an emerging economy as each additional unit of capital and labor offers a high return. As the economy grows their returns diminish as the relatively inefficient services sector grows relative to manufacturing. Intervening against currency appreciation accelerates this transition by importing easier Fed[eral Reserve] policy. But with a mispricing of capital, it typically leads to an over usage, inefficiencies and in some cases excessive domestic valuations. As growth slows down structurally, the promises of ever stronger growth fades leaving investors potentially with unsustainable debt levels.
China, which has seen its marginal return on credit growth continue to shrink, is perhaps the poster child for the sequence Galy describes.
This course of events has led Beijing to begin drawing down on its foreign reserves, which are primarily composed of U.S. debt, in a move that puts upward pressure on U.S. Treasury yields and has the opposite effect on the value of the dollar.
This dynamic, however, is swamped by the appetite for Treasuries from the private sector, says the strategist.
"Foreign reserves reduced their duration ahead of Fed tightening and as they decline in importance, private demand must compensate [for] additional issuance," wrote the strategist, observing that Treasury yields remain quite attractive relative to the return available on European or Japanese debt. "A dearth of safe yielding assets globally means that [selling by reserve managers] is easily absorbed."
Repatriation will be fueled primarily by portfolio outflows from riskier emerging market positions and sovereign wealth fund liquidations. Since U.S. investors have far and away the highest stock of foreign equity ownership, this trend is also conducive to more greenback strength.
In fact, Galy found that "during the rapid rise in the dollar in 2015, the foreign exchange hedging decision had a clear causal and feedback loop on the spot price." That is, as the dollar rose, more investors chose to use hedged equity exchange-traded funds, which provided an impetus for further gains in the greenback.
Emerging markets, meanwhile, will suffer from elevated debt loads, lower growth prospects, and higher costs of servicing dollar-denominated debt.
"[The risk of portfolio outflows] also leads to a tightening of monetary conditions in countries heavily reliant on foreign funding and a limited perceived chance of getting a dollar swap facility," added Galy, citing Russia as an example of such a country.