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  • Sep 3, 2014
  • Updated: 11:09am
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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

PUBLISHED : Thursday, 13 February, 2014, 11:44am
UPDATED : Friday, 14 February, 2014, 4:28am

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.

Investors are becoming concerned about lack of growth in emerging markets

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


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If you think I'm too anti-IMF or anti-US, then you should also read the following article to balance your own view.
('The Dollar and the Damage Done', Project Syndicate, FEB 13, 2014)
The US has renationalized the international lender-of-last-resort function. Simply put, the Fed is the only emergency source of dollar liquidity still standing.
(Ignoring China's rich US$ reserve, that is.)
But US's permanent dollar-swap-line arrangement only favours a few privileged countries, her true allies, to the exclusion of all EM countries.
By now, the EM countries should see clearly whether the US is truly a friend that can be fully trusted by them.
According to Abraham Lincoln, you can fool all the people some of the time, and some of the people all the time, but you cannot fool all the people all the time.
If you don't believe me, watch Spider-man 2.
There, not even the powerful spiderman could stop the running train at once.
It's just common sense.
Also in Spiderman, uncle Ben said that 'with great power there must also come great responsibility.'
Spiderman took his advice, so he had to keep a distance from his beloved Mary Jane.
That's his curse, his destiny, and his responsibility.
In case of the present EM crisis, this mantra doesn't apply to the IMF led by the advanced western nations, or to Yellen's Fed of the US.
They sat on the sideline, and watched the drama unfold.
So, either the mantra is wrong, or, more probably, there must be something wrong with the present international financial arrangement.
Or so I think.
It's said that when the money is flowing out, the right thing to do is to let it go.
You can't stand in front of a coming train and try to stop it at once.
Of course you don't have to try it to believe me.
Only after the train has (almost) completely stopped can you do something about it.
Obviously, raising massively the domestic interest rate has bad consequences as well.
It has been said that one way out is for all the affected countries to group together and lower, not raise, their interest rates.
Of course the right thing to do is to restructure their economies and increase their overall productivities and competitiveness when the time is good.
But once again this is easier said than done.
It's said that the hot money's flowing in and out of the EM countries has been facilitated by the more widespread use of the ETFs.
The conventional interplay of greed and fear still reigns supreme --- for the EM countries (and the commodities market) the cycle is in terms of years, for the stock market, in terms of months, days or even hours --- perhaps minutes.
Human is human, there's no way of changing it, and no need to do so really.
To profit from the cycle, or avoid being hurt by it, it's critical to get the timing right.
But this is much easier said than done.
I think Baron Rothschild's wisdom is still useful nowadays --- never buy at the bottom, always sell too soon.
And of course read the morning post every day.
Sorry, I mean every hour.


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