Russ discusses the catalysts favoring Emerging Markets, beginning with the Federal Reserve.

Starting in late August two things happened that had not occurred in several years: The Federal Reserve started expanding its balance sheet and emerging markets began outperforming. The two are intimately related and are likely to continue.

Back in July I highlighted the importance of monetary and broader financial conditions for emerging markets. While the price and availability of money matters for all risky assets, emerging markets are particularly sensitive, even more so since the financial crisis. The pivot by the world’s central banks, not just lowering rates but reverting back to asset purchases, has proved a game-changer for this asset class.

Raining cash

Ironically, stress in U.S. money markets was the catalyst that provided a boost for emerging market stocks. Starting in the fall the Fed began providing additional liquidity in order to stabilize money markets. Part of this effort involved resuming their asset purchases.

As a result, after declining for several years the Fed’s balance sheet began to aggressively expand. From August 31st through the end of the year, Fed asset holdings increased by approximately $400 billion. As a percentage of gross domestic product (GDP) the Fed’s balance sheet went from 17.6% to 19.3%.

A rapidly expanding balance sheet and the accompanying liquidity coincided with strong performance from emerging market equities. The MSCI EM Index gained roughly 13% versus a bit more than 10% for developed markets. Even with the United States finishing the year in a spectacular fashion, emerging market equities outperformed their developed market cousins by over three percentage points.