The end of QE2 and emerging market equities.

Emerging market (EM) investors have begun to worry about the end of the second round of quantitative easing (QE2) in mid-year. The concern has been that higher U.S. yields would boost the cost of capital in EMs and threaten equity valuations. Yet recently, markets imply that the risk is in the other direction -- economic worries in the U.S. and falling Treasury yields. While our Macro Strategy team expects yields to fall near-term as they did at the end of QE1, our economists forecast US 10-year yields to rebound to 3.6% by Q4, a fairly modest increase of 40-50 basis points (bp) from current levels. Such a yield increase should pose little risk to emerging markets and would present a positive backdrop for EM equities.

Around recent periods of quantitative easing (QE), the direction of flows to or from risky assets -- not Fed bond market activity -- has driven EM equities. Bond yields (U.S. and EM) and EM equities have risen during the two QE periods, while falling during the period between QE1 and QE2 on U.S. double-dip fears last summer. The key for EMs has been spreads, which fell in the two QE periods and rose when QE1 ended.

There is little pattern of regional performance during the two periods of QE. In QE1, Latin America outperformed; in QE2, Asia and EMEA have done well. Growth/risky markets did very well in QE1, slightly less well in QE2. Between QE1 and QE2, defensive Asia led the way and small markets did well. Sectors have been more predictable. In QE periods, high-beta sectors have outperformed. Between QE1 and QE2, a bias towards domestics and defense paid off with consumer staples, telecoms and utilities doing well.

With new doubts over U.S. growth and the Fed set to step away from the bond market, EM investors may wish to turn defensive. However, with U.S. yields already down over 50bp since February, little risk, in our view, of a repeat of the scale of double-dip scare of last summer and EMs struggling, it may be too late for defense.

It is too early to speculate over yet another round of quantitative easing, although we have heard many investors argue that this will be needed. A QE3 scenario (which our economists do not expect) would seem to favor a very aggressive growth/risk portfolio, with overweights in global and domestic cyclicals. In this event, U.S. growth plays, such as Mexico, Korea and Taiwan, would also be attractive.

EM equities trade at a yield premium of 19% to EM bonds; any modest rebound over time in the cost of capital is, therefore, little threat to EM equities. We stay positive; this latest worry for equity markets should pass also.

NOTE: This piece is adapted from a Citi Global Equity Strategy note entitled "The End of QE2 and Emerging Markets," published on May 5, 2011.