Emerging markets the new focus for investors' fears
Emerging markets have become the new focus for investors' fears, leading to capital outflows, sharp falls in local currencies and interest rate rises
Even at the best of times, financial markets can be awfully fickle.
So it's not surprising that investors are uncertain about how best to position themselves for the opportunities and risks arising from the two big shifts in global monetary policy that are just beginning to play out: the scaling back, or "tapering", of the US Federal Reserve's programme of quantitative easing and China's attempts to tame its credit boom.
The most telling aspect of this uncertainty, as noted by last month's global fund manager survey conducted by Bank of America Merrill Lynch, is the apparent disconnect between equity investors' sanguine outlook for global growth and their extreme bearishness about emerging markets (EMs).
According to the survey, "rarely have such bullish growth expectations mixed with such bleak EM weightings".
This suggests that investors believe emerging markets won't benefit from the recovery in developed economies. They reckon the sell-off in the developing world has further to run.
The scope for a more severe deterioration in market conditions in emerging markets is indeed significant.
But this is partly because jittery investors are demanding policy responses from emerging market central banks that they are in two minds about.
The stakes are extremely high.
If emerging markets, which together account for nearly half of global gross domestic product, are forced by markets to pursue excessively tight monetary policies that crimp growth at a time when their economies are already slowing, growth in the developed world will suffer, too.
The problem is that while the underlying woes of emerging markets are home-grown, sentiment towards the asset class is strongly shaped by investors' perceptions of Fed tapering and China's attempts to engineer a soft landing for its economy.
The most vulnerable emerging markets, while having put themselves at risk by failing to manage the adverse effects of capital inflows and delaying much-needed structural reforms, have become proxies for market concerns about the policies of the Fed and the People's Bank of China.
The conduct of monetary policy in emerging markets has replaced fears about the break-up of the euro zone as the focal point for investor nervousness.
The value of the Turkish lira and the South African rand against the US dollar has supplanted the yields on Spanish and Italian bonds as the main gauge of market anxiety.
The foreign capital outflows that southern Europe suffered at the height of the euro-zone crisis in 2011 and 2012 are now roiling emerging markets, leading to sharp falls in local currencies and forcing central banks to raise interest rates to restore confidence - particularly in those countries, such as India and Brazil, which are already suffering from high inflation rates.
Yet markets should be careful what they wish for.
Just as investors started fretting about the risk of too much fiscal austerity in the euro zone, they are now becoming increasingly concerned about the lack of growth in emerging markets.
The Turkish central bank's decision on January 28 to raise its benchmark interest rate by a whopping 450 basis points to 10 per cent - hastily arranged and announced at midnight - had a whiff of panic about it and did little to restore confidence in Turkish monetary policy.
On Friday, Standard & Poor's cut the outlook on Turkey's credit rating to negative, claiming the country's "policy environment is becoming less predictable" and warning of the growing risk of a "hard economic landing".
What's more, the day after Turkey's central bank tightened monetary policy aggressively, its South African counterpart surprised markets with an earlier-than-expected 50 basis point rise in interest rates mainly aimed at shoring up the wilting rand.
Markets are now starting to price in heftier rate rises in emerging markets like Hungary and Poland, which have extremely low rates of inflation and whose economic recoveries have only just begun.
The longer that fear and uncertainty pervade the emerging market asset class, triggering further outflows from emerging market bond and equity funds (which already total US$5.7 billion and US$18 billion, respectively, this year), the greater the risk that central banks will be forced to tighten monetary policy excessively, imperilling growth further and undermining the credibility of the policymaking regimes in emerging markets.
Fortunately, however, the most reassuring aspect of the sell-off in emerging markets is that foreign institutional bond investors are keeping the faith.
The selling pressure in emerging markets is coming from the more speculative retail investors, particularly US and Europe-based mutual funds.
Foreign institutional holdings of emerging market local currency debt have not fallen significantly since the Fed let the "tapering" genie out of the bottle.
There's still hope for emerging markets.
Nicholas Spiro is the managing director of Spiro Sovereign Strategy