Emerging markets: A crisis of confidence
Investors, bankers and policymakers were caught off-guard in early 2014 as new depths of pessimism about emerging markets were plumbed.
The US Federal Reserve is providing quantitative easing at a moderately slower pace, relative to a record level of expansion. Most China forecasts imply Beijing will succeed in its balancing act – stabilizing growth while embarking on reforms. And relatively weak emerging markets expansion, more generally, is old, 2010-era news.
And yet financial markets are weeping. The latest cycle of panic over China is attributed to fears that Beijing might be doing too much to rein in credit, even after markets have fretted for years that the government was doing nothing to control its explosion.
Economists are scratching their heads over the fact that emerging market exports are failing to stage a recovery even with a tentative pick-up in developed markets. Few expected markets would suddenly decree a loss-of-confidence crisis in emerging market central banks of deficit nations without aggressive remedial action, with echoes of the Asia crisis of 1997/98.
And real-money managers would have baulked at the suggestion that US treasuries would become the best-performing asset class in early 2014 given the overwhelming consensus in favour of a spirited US rebound while the so-called January effect typically boosts risk assets.
This unexpected chain of events has shaken the confidence of battle-hardened emerging market veterans. There’s no doubt there are huge returns to be made this year – getting the Turkish domestic rate call alone could be the stuff of legend for years to come.
But with Europe and Japan trying to export their way to expansion, and reduced capacity for credit- and domestic-driven growth in the larger developing markets, a cloud of doubt hovers over emerging market FX, equity returns, as well as banks’ trading and investment-banking revenues from Asia to Latin America.
As a result, there is a notable lack of consensus. For example, projected local-currency debt returns by the end of the year vary wildly, with JPMorgan forecasting -0.3% in contrast to Standard Bank’s +7%, even with a broad agreement on global expansion and US treasuries, underscoring uncertainty over emerging markets, specifically.
Bulls point out that the sell-off is a healthy cyclical correction to normalize pricing for emerging market sovereigns and corporates after a prolonged era of capital misallocation during QE, while local-currency weakness and rising domestic rates have largely left sovereign credits intact, buttressing the asset class’s reputation.
What’s more, record hard-currency emerging market issuance between January and early February suggests there is no emerging market-wide crisis. Deficit nations are correcting imbalances and no big corporate defaults, post-Brazilian Eike Batista’s OGX group, are expected this year.
Meanwhile, real-money funds and family offices are strategically increasing allocations, despite retail outflows and hedge-fund shorts. The market over-reaction should even help to arouse Bric policymakers from their reformist slumber, say bulls.
Even amid a tentative recovery in EM risk-on trades, and relatively attractive valuations, this might be wishful thinking. There are so many potential pressure points: a recession in Turkey, a Brazilian sovereign downgrade to junk, a credit event in Ukraine. Any or all could weigh on emerging market sentiment.
Those at the centre of the possible storm are worried. Pravin Gordhan, South Africa’s finance minister, tells Euromoney this month that South Africa must be given space to correct its economy without resorting to austerity.
Gordhan, like many of his peers, will hope that the optimism of the deputy governor of Turkey’s central bank is not misplaced. Turalay Kenc tells us: "This is mainly a portfolio outflow. It has to do with repricing of emerging markets risk due to the impact of the Fed’s unconventional monetary policy."
Crossover investors, as demonstrated in the first six weeks of the year, will overstate the weakness in emerging market fundamentals, if capital inflows are weak, reverting to Asia-crisis-era biases. Meanwhile, the prospect of a domestic policy mis-step has increased given FX volatility, deleveraging and the need for structural reforms.
A chain of confidence-building events is needed to ensure emerging markets trade back in line with fundamentals. And a touch of realism.
As an exasperated Gordhan says: "In the 2008 to 2012 cycle, emerging markets were providing the growth dynamic. Now, because you have slightly better growth in the west, it doesn’t mean that all emerging markets are basket cases."