Weak growth supplants Fed as main challenge for emerging markets
Two key economic data releases in the past week have thrown the shifting landscape of investor sentiment towards emerging markets (EMs) into sharp relief.
Last Friday, a closely watched gauge of wage growth in the US known as the Employment Cost Index (ECI) showed that salaries in the second quarter of this year grew at their slowest pace since 1982.
With the Federal Reserve setting great store by an improvement in the labour market as a condition for raising interest rates, the dollar and US bond yields immediately fell following the publication of the report as investors reassessed both the timing and pace of the anticipated tightening in policy.
On Monday, a final reading of the health of China’s closely watched manufacturing sector last month showed that output contracted at a sharper pace than expected, with the sector shrinking for the fifth consecutive month and manufacturers cutting production at the fastest rate since November 2011.
In the space of 72 hours, two of the three key determinants of sentiment towards EMs - the conduct of US monetary policy and the performance of developing economies (the third one is the prices of commodities which have been falling sharply over the past few months) - vied with each other in influencing market conditions. Judging by the extremely fragile mood in equity markets and the persistent weakness in the commodity complex, the latter is having a stronger bearing on sentiment.
On the face of it, this is bad news for EMs.
If country-specific weaknesses and vulnerabilities - particularly in China - are taking over from the anticipated rise in US interest rates as the most important factor determining how investors perceive and price EMs, then market conditions are likely to become even more volatile once the so-called “lift-off” occurs.
It is worth recalling that when the Fed signalled in May 2013 that it planned to start winding down, or “tapering”, its programme of quantitative easing (QE), developing economies were in much better shape.
For 2013 as a whole, Brazil still managed to grow by nearly 3 per cent while Russia expanded by nearly 1.5 per cent. This year, both economies are expected to contract by 1.5 per cent and 3.4 per cent respectively, according to the latest forecasts from the IMF.
Indeed the Fund expects growth in the developing world this year to slow to 4.2 per cent, compared with 5 per cent in 2013. The commodity-rich Latin American region will barely grow this year - 0.5 per cent compared with 2.1 per cent for advanced economies - while Southeast Asia will expand by 4.7 per cent.
The big danger for EMs is that a vicious circle develops in which mounting concerns about China, the sell-off in commodities, domestic political and economic weaknesses and the uncertainty regarding the fallout from a rise in US interest rates all start to feed on each other, leading to a prolonged deterioration in sentiment.
Indeed this is already happening to some extent.
Still, a shift in the balance of perceived risks in EMs away from a tightening in US monetary policy and towards home-grown weaknesses could, if sustained, prove to be a stronger catalyst for much-needed economic reforms.
EM governments, especially those that are reluctant to undertake reforms, are now finding it more difficult to pin the blame on the Fed for the deterioration in market conditions.
Some of the EM countries that suffered the sharpest declines in their currencies over the past few months are those facing major political and economic problems.
The Turkish lira, which has fallen more than 8 per cent against the dollar since mid-May, is vulnerable because of a debilitating political crisis. The country’s main political parties are unable to agree on the formation of a coalition government following a parliamentary election in June. A snap election is now a distinct possibility.
The Malaysian ringgit, meanwhile, which has fallen 7.5 per cent, is under strain partly because of an escalating corruption probe into 1MDB, the heavily indebted state investment fund whose advisory board is chaired by the country’s premier.
The more investors fret about country-specific risks as opposed to the anticipated tightening in US monetary policy, the greater the pressure on governments to implement reforms.
Unfortunately even the less vulnerable EMs are finding it difficult to reform. India’s parliament is stymieing efforts by the government to overhaul the country’s tax system while Mexico is struggling to attract foreign investment into its oil sector. Seen from this perspective, a gradual rise in US interest rates may prove to be the least of developing economies’ problems.
Nicholas Spiro is managing director of Spiro Sovereign Stragegy