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August 23, 2013 1:33 pm
Correction or crisis? That is the question for emerging markets. The selling of the past few weeks in currencies such as the Indian rupee has – so far at least – merely been a correction of an imbalance that had been growing for at least a decade. But markets can build a momentum of their own. Could this become a crisis?
First, let us look at how emerging markets investing has played out during the past decade. Although dressed up with different names (such as “Brics” investing, for Brazil, Russia, India and China), the greatest driver of emerging market assets has been money sluicing in, especially from the US.
Starting in 2002 (when the Federal Reserve under Alan Greenspan slashed rates after the end of the internet bubble), dollars poured in to emerging markets. This was a form of “carry trade” as investors borrowed cheaply in dollars, and put money where it could earn a higher return. As this tended to push down the dollar, and as China’s growth helped build up foreign exchange reserves still further, the trade worked very well.
However, that reserve build-up stalled in 2011. Chinese officials, worried by asset bubbles at home, no longer seem keen to build reserves. Faith in the Chinese growth story, on which many western investors had come to rely, has been shaken. And emerging markets’ gains have tailed off severely. As the chart shows, all of the Brics’ outperformance of US stocks since 2006 has now been cancelled out.
This steady shift became far more rapid as US bond yields began to rise in earnest this year. This was largely because the Fed’s chairman, Ben Bernanke, began to talk about “tapering off” its purchases of Treasury bonds. This would allow rates to rise, and tapering might well start at the Fed’s meeting next month. Rising interest rates in the US automatically make an emerging market “carry trade” less appealing.
So far, selling of both currencies and stocks has been greatest for countries with current account deficits. Research by John Lomax of HSBC shows that emerging markets that run a surplus started sharply outperforming those with deficits in May, and this outperformance has been almost perfectly correlated with the rise in bond yields. This suggests that equity investors are worried that this could turn into an old-fashioned crisis, in which devaluations force big importers into severe inflation. This explains the worries about India.
But much of this can be seen as a correction. Emerging market assets have been boosted by flows that were artificial. Many had complained that their currencies were too strong, making life hard for their exporters. Brazil even alleged that the west was waging a “currency war”. Now that Brazil’s real has fallen 38 per cent against the dollar in two years, almost down to its 2008 crisis low, such complaints have gone quiet.
Flexible exchange rates in any case make it harder for a traditional crisis to happen. The disasters that befell Mexico in 1994, and southeast Asia in 1997, happened when currency pegs suddenly snapped. Now, currencies can act as a safety valve; many countries in peripheral Europe would be only too delighted to devalue at this point. With their war chest of reserves – which many central banks are now beginning to spend – and with far more of their debt now denominated in local currencies, it ought to be possible to correct the extremities of the past decade without triggering crises or recessions.
Further, we are nearing the point where emerging market stocks offer true value. Based on cyclically adjusted price/earnings ratios, research by Mebane Faber of Cambria Investment Management shows that at the end of July, only Indonesia and Thailand (and to a lesser extent Malaysia and South Africa), looked more expensive than their long-term norm. China, Brazil, Russia and Peru all looked notably cheap.
In comparison to their book value, emerging market stocks are as cheap as they have been in a decade, barring a few months during the worst of the crisis in 2008.
For those who can wait 10 years, then, some emerging markets begin to look compelling. But there are two caveats.
First, emerging market performance during the past decade, driven by the weak dollar, is no guide to future returns. Nobody should expect gains, in relative or absolute terms, on anything like the scale seen during those years. We are ushering in to a new and quieter phase.
And second, diving in during the next few weeks would be dangerous. At least until the Fed announces its decision on tapering, the sell-off in Treasuries could easily grow uglier. The 10-year rally was driven by US money and the same applies to this sell-off.
This is not – yet – a crisis, and the reforms and improvements of the past decade mean that a crisis ought to be avoidable. But if Treasury bonds suffer a disorderly rout, which is possible, the greatest victims would be the emerging markets.
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