http://www.prudentbear.com/2013/09/difficult-decisions-ahead.html
Difficult Decisions Ahead
September 6, 2013
The repricing of global bonds continued, despite escalating tensions in Syria and soft payroll data.
The latest G20 meeting was dominated by deep divisions over Syria in an increasingly divisive global backdrop. The Middle East is precariously divided. In Europe, leaders remain deeply divided over how best to deal with Eurozone issues. The American population is deeply divided on political, social and economic issues. Congress is deeply, deeply divided on seemingly everything. The Federal Reserve is divided on the merits of unconventional measures and the future course of policymaking. The emerging markets (EM) see developing world monetary policy as highly destabilizing, with QE having stoked “hot money” inflows and “tapering” risking problematic outflows.
Within the G20, common interests have been largely supplanted by mistrust and, seemingly, irreconcilable differences. Members these days lack even a European crisis response to try to rally around. I believe the “G” conferences have basically lost the capacity to have real impact on very serious ongoing global financial and economic issues. One could argue that traditional frameworks for myriad key policy decisions – from monetary policy to crisis response to acts of war – are being transformed before our eyes. This ensures added uncertainty in an already uncertain world. Markets see only QE.
The “Credit Bubble Bulletin” focuses (ok, fixates) on Credit. I strive to keep my analysis close to home, steering clear of political debate and geopolitical pontification. Yet Credit – sound or, more pertinently, otherwise – has a profound impact on wealth (creation and destruction) and wealth distribution. Protracted Credit Cycles – with their attendant booms, busts and destruction - have momentous impacts on societies and geopolitics. I work to provide an accurate chronicle of relevant events.
It’s been my thesis that we’re at the late phase of a historic global Credit boom. During much of the Bubble’s upside, the global economic pie was getting bigger. This provided powerful impetus to mutual interests, cooperation and integration. There was the capacity to forge international consensus on various pressing financial and economic issues – as well as even the ability to muster a “coalition of the willing” for major military operations.
The world is transitioning into a quite different environment. Despite desperate measure after desperate measure, a most over-extended global Bubble is convulsing erratically. The economic pie is stagnating - and on its way to contracting. This dynamic ensures an increasingly powerful pull of diverging interests, disagreement, fragmentation and confrontation.
The world has turned increasingly skeptical of U.S. policymaking, certainly including monetary policy. Round the globe, citizens and their leaders have grown tired of cooperating on just about everything - from finance to climate change to global policing. This runs up against heightened need for all of the above in an increasingly disorderly and hostile - faltering Bubble - world.
I have argued that desperate monetary inflation stoked a dangerous divergence between inflated global securities prices and deteriorating fundamental prospects. With U.S. equities near all-time highs, the market and media focus remains on Mr. Brightside. The cautious and darn right skeptical have been discredited and shoved out of the way. It has been easy to disregard the unstable global geopolitical backdrop. It’s been easy to ignore the rapidly deteriorating situation in the Middle East. With the Fed injecting unprecedented amounts of liquidity into overheated markets, it has been effortless – and highly profitable – to ignore risk more generally. Indeed, the bullish view holds that we’re in the initial phase of a new bull market – and, surely, a return to robust global growth, prosperity and cooperation.
There will come a point where the divergence between Bubbling securities markets and a sobering reality is narrowed. The longer massive monetary inflation extends this gap, the more destabilizing the eventual market dislocation. The greater the global market dislocation the greater the strain on economies, societies and alliances. And, in contrast to conventional thinking and that of the Fed, a lot of damage can be wrought in relatively short order when finance is running amuck. It’s reached the point where QE has minimal benefit, while dilly dallying and “tapering” bear great costs.
Yet with global markets having come to wield unprecedented influence on Credit, perceived wealth, economic activity and overall cohesion, the temptation for central banks to continue sustaining market Bubbles is just too great. This dynamic creates great uncertainty, while at the same time further opening the window of opportunity for destabilizing speculative excess.
Understandably focused on economic issues at home, American public opinion is strongly opposed to intervention in Syria. Understandably focused on economic and domestic interests at home, few in the global community are willing to join the U.S. on Syria. President Obama has very Difficult Decisions Ahead.
The Federal Open Market Committee faces its own Difficult Decisions of its own making. It’s notoriously difficult to withdraw monetary accommodation. Central banks are invariably late in removing the punchbowl. Perhaps more pertinent, there is never a painless path to ending aggressive monetary inflation. And that’s precisely why history demonstrates that once the process of “money” printing (currency or “virtual”) is embraced it becomes nearly impossible to dis-embrace. The past five years (or, if you choose, go back 20) have illustrated how one bout of seemingly innocuous monetary inflation invariably begets proliferation and, in the end, intransigent monetary disorder. The big unknown is how this historic global experiment in central bank management of unrestrained, market-based electronic “digital” money and Credit plays itself out.
This is an inopportune time for the emerging markets to face any moderation of Federal Reserve accommodation. But this dilemma was inevitable. When the U.S. and the developed world moved aggressively with post-mortgage finance Bubble reflationary measures, EM was the “fledgling Bubble” poised to be on the receiving end of unparalleled liquidity flows. Global Credit systems and economies diverged. In time, interests would diverge. For going on five years now, loose money and increasingly aggressive QE pushed EM financial and economic Bubbles to precarious extremes. Meanwhile, developed world recoveries badly lagged. The “money” flowed and latent global fragilities mounted.
Over the past year, incredible measures by the ECB, Fed and BOJ have had major effects. EM “terminal phase” Bubble excess was granted a bonus year to wreak havoc. In the U.S., stock prices inflated about 30%, as speculation went into overdrive. Throughout the U.S. corporate debt market (and only to a somewhat lesser extent globally), Bubble excesses ran wild. In the real economy, rapid price inflation reemerged in housing markets across the country. Quite simply, powerful Bubble conditions intensified, and an expanding number of sectors within the economy began to participate.
Considering the backdrop, $85bn monthly QE is inappropriate – I would argue reckless, a 7.3% unemployment rate notwithstanding. But both the global financial and economic spheres have grown addicted to aggressive monetary inflation. EM Bubble fragility has turned conspicuous. There is the global securities market Bubble, most obvious in mispriced bond markets around the world. There are less appreciated Bubbles in global equities and the “global leveraged speculating community” more generally. All in all, there is ample global financial and economic fragility to ensure the most timid rendition of monetary policy restraint imaginable.
On the one hand, I believe a global re-pricing of debt securities has commenced. On the other, there remains sufficient global monetary inflation and emboldened “animal spirits” to beg the question: How crazy do things get?
Syria is a frightening place. It’s in a tough and rapidly disintegrating region. The situation has regressed into the much feared “proxy war” on too many fronts. And it doesn’t take a wild imagination to see Syria as a catalyst for escalating global tensions that could stumble into a major confrontation. The Russians and Iranians are staring President Obama down.
Meanwhile, outside of crude oil, global markets show minimal concern. After all, analysts suggest it could be up to two more weeks – a veritable eternity for a speculative marketplace - before the President might act. Besides, non-farm payroll data were soft. This is expected to only further embolden the dovish contingent that was already pushing against any move to reduce accommodation (this week from Kocherlakota and Evans). It was another week that illuminated dichotomies. The reality is that the world is in the midst of far-reaching – I’m convinced troubling - changes. The market reality is that primary focus remains on the monetary backdrop.
The " Squid " discusses E.M ......
Submitted by Tyler Durden on 09/07/2013 11:20 -0400
The latest G20 meeting was dominated by deep divisions over Syria in an increasingly divisive global backdrop. The Middle East is precariously divided. In Europe, leaders remain deeply divided over how best to deal with Eurozone issues. The American population is deeply divided on political, social and economic issues. Congress is deeply, deeply divided on seemingly everything. The Federal Reserve is divided on the merits of unconventional measures and the future course of policymaking. The emerging markets (EM) see developing world monetary policy as highly destabilizing, with QE having stoked “hot money” inflows and “tapering” risking problematic outflows.
Within the G20, common interests have been largely supplanted by mistrust and, seemingly, irreconcilable differences. Members these days lack even a European crisis response to try to rally around. I believe the “G” conferences have basically lost the capacity to have real impact on very serious ongoing global financial and economic issues. One could argue that traditional frameworks for myriad key policy decisions – from monetary policy to crisis response to acts of war – are being transformed before our eyes. This ensures added uncertainty in an already uncertain world. Markets see only QE.
The “Credit Bubble Bulletin” focuses (ok, fixates) on Credit. I strive to keep my analysis close to home, steering clear of political debate and geopolitical pontification. Yet Credit – sound or, more pertinently, otherwise – has a profound impact on wealth (creation and destruction) and wealth distribution. Protracted Credit Cycles – with their attendant booms, busts and destruction - have momentous impacts on societies and geopolitics. I work to provide an accurate chronicle of relevant events.
It’s been my thesis that we’re at the late phase of a historic global Credit boom. During much of the Bubble’s upside, the global economic pie was getting bigger. This provided powerful impetus to mutual interests, cooperation and integration. There was the capacity to forge international consensus on various pressing financial and economic issues – as well as even the ability to muster a “coalition of the willing” for major military operations.
The world is transitioning into a quite different environment. Despite desperate measure after desperate measure, a most over-extended global Bubble is convulsing erratically. The economic pie is stagnating - and on its way to contracting. This dynamic ensures an increasingly powerful pull of diverging interests, disagreement, fragmentation and confrontation.
The world has turned increasingly skeptical of U.S. policymaking, certainly including monetary policy. Round the globe, citizens and their leaders have grown tired of cooperating on just about everything - from finance to climate change to global policing. This runs up against heightened need for all of the above in an increasingly disorderly and hostile - faltering Bubble - world.
I have argued that desperate monetary inflation stoked a dangerous divergence between inflated global securities prices and deteriorating fundamental prospects. With U.S. equities near all-time highs, the market and media focus remains on Mr. Brightside. The cautious and darn right skeptical have been discredited and shoved out of the way. It has been easy to disregard the unstable global geopolitical backdrop. It’s been easy to ignore the rapidly deteriorating situation in the Middle East. With the Fed injecting unprecedented amounts of liquidity into overheated markets, it has been effortless – and highly profitable – to ignore risk more generally. Indeed, the bullish view holds that we’re in the initial phase of a new bull market – and, surely, a return to robust global growth, prosperity and cooperation.
There will come a point where the divergence between Bubbling securities markets and a sobering reality is narrowed. The longer massive monetary inflation extends this gap, the more destabilizing the eventual market dislocation. The greater the global market dislocation the greater the strain on economies, societies and alliances. And, in contrast to conventional thinking and that of the Fed, a lot of damage can be wrought in relatively short order when finance is running amuck. It’s reached the point where QE has minimal benefit, while dilly dallying and “tapering” bear great costs.
Yet with global markets having come to wield unprecedented influence on Credit, perceived wealth, economic activity and overall cohesion, the temptation for central banks to continue sustaining market Bubbles is just too great. This dynamic creates great uncertainty, while at the same time further opening the window of opportunity for destabilizing speculative excess.
Understandably focused on economic issues at home, American public opinion is strongly opposed to intervention in Syria. Understandably focused on economic and domestic interests at home, few in the global community are willing to join the U.S. on Syria. President Obama has very Difficult Decisions Ahead.
The Federal Open Market Committee faces its own Difficult Decisions of its own making. It’s notoriously difficult to withdraw monetary accommodation. Central banks are invariably late in removing the punchbowl. Perhaps more pertinent, there is never a painless path to ending aggressive monetary inflation. And that’s precisely why history demonstrates that once the process of “money” printing (currency or “virtual”) is embraced it becomes nearly impossible to dis-embrace. The past five years (or, if you choose, go back 20) have illustrated how one bout of seemingly innocuous monetary inflation invariably begets proliferation and, in the end, intransigent monetary disorder. The big unknown is how this historic global experiment in central bank management of unrestrained, market-based electronic “digital” money and Credit plays itself out.
This is an inopportune time for the emerging markets to face any moderation of Federal Reserve accommodation. But this dilemma was inevitable. When the U.S. and the developed world moved aggressively with post-mortgage finance Bubble reflationary measures, EM was the “fledgling Bubble” poised to be on the receiving end of unparalleled liquidity flows. Global Credit systems and economies diverged. In time, interests would diverge. For going on five years now, loose money and increasingly aggressive QE pushed EM financial and economic Bubbles to precarious extremes. Meanwhile, developed world recoveries badly lagged. The “money” flowed and latent global fragilities mounted.
Over the past year, incredible measures by the ECB, Fed and BOJ have had major effects. EM “terminal phase” Bubble excess was granted a bonus year to wreak havoc. In the U.S., stock prices inflated about 30%, as speculation went into overdrive. Throughout the U.S. corporate debt market (and only to a somewhat lesser extent globally), Bubble excesses ran wild. In the real economy, rapid price inflation reemerged in housing markets across the country. Quite simply, powerful Bubble conditions intensified, and an expanding number of sectors within the economy began to participate.
Considering the backdrop, $85bn monthly QE is inappropriate – I would argue reckless, a 7.3% unemployment rate notwithstanding. But both the global financial and economic spheres have grown addicted to aggressive monetary inflation. EM Bubble fragility has turned conspicuous. There is the global securities market Bubble, most obvious in mispriced bond markets around the world. There are less appreciated Bubbles in global equities and the “global leveraged speculating community” more generally. All in all, there is ample global financial and economic fragility to ensure the most timid rendition of monetary policy restraint imaginable.
On the one hand, I believe a global re-pricing of debt securities has commenced. On the other, there remains sufficient global monetary inflation and emboldened “animal spirits” to beg the question: How crazy do things get?
Syria is a frightening place. It’s in a tough and rapidly disintegrating region. The situation has regressed into the much feared “proxy war” on too many fronts. And it doesn’t take a wild imagination to see Syria as a catalyst for escalating global tensions that could stumble into a major confrontation. The Russians and Iranians are staring President Obama down.
Meanwhile, outside of crude oil, global markets show minimal concern. After all, analysts suggest it could be up to two more weeks – a veritable eternity for a speculative marketplace - before the President might act. Besides, non-farm payroll data were soft. This is expected to only further embolden the dovish contingent that was already pushing against any move to reduce accommodation (this week from Kocherlakota and Evans). It was another week that illuminated dichotomies. The reality is that the world is in the midst of far-reaching – I’m convinced troubling - changes. The market reality is that primary focus remains on the monetary backdrop.
The " Squid " discusses E.M ......
Goldman's Quick Answers To Tough EM Questions
As most know by now, over the past month or so, pressure on the currencies of EM deficit countries has intensified again. Goldman's EM research group, however, remains negative on EM FX, bonds, and even stocks suggesting using any strength, like this week's exuberance to add protection or cover any remaining longs. Central banks in most of these countries have become more active in attempting to stem pressure in the last two weeks. But with a Fed decision on ‘tapering’ looming, investors have also become more cautious and are now focused on the parallels with prior crisis periods. In what follows, Goldman provides some concise answers to the questions on the EM landscape that we encounter most often, confirming their longer-held bearish bias.
Goldman Sachs: Quick Answers To Tough EM Questions
Q. Why have EM assets performed so poorly over the past several months?
A more challenging environment as global rates rise and China downshifts
Much of the recent poor performance of EM assets is linked to two dynamics that are likely to be with us for some time:
(1) A post-housing-bust normalisation in the US. As the US shifts to above-trend growth and the Federal Reserve gradually reduces its unprecedented monetary stimulus, this places upward pressure on EM rates and downward pressure on currencies. For those with financing needs – and above-target inflation – managing this kind of adjustment is likely to remain particularly challenging.(2) A downshift in Chinese growth as the authorities focus on credit excesses, the anti-corruption drive and ensuring the sustainability of medium-term growth. This puts downward pressure on China-linked assets, especially commodities and EM equities.
Through most of this year, one or other of these forces – and sometimes both – has been in play. The most recent leg of EM asset underperformance, focused on FX weakness in Indonesia, India and Turkey, was clearly related to the first and to the expectation of Fed tapering later this month.
Arguably, the big picture story is even simpler. The US housing slowdown, DM demand collapse and subsequent deleveraging – as well as the unprecedented monetary easing to deal with it – forced a series of adjustments on many EM economies (Exhibit 1). They boosted domestic demand to offset the external shortfall, through monetary, fiscal and sometimes direct credit stimulus. Currencies appreciated as capital flowed in – a pressure that was partly mitigated by reserve accumulation and partly by sharper cuts to interest rates than domestic conditions alone would have justified. This mix was generally a success in cushioning the EM universe from the DM slowdown. But it often came with stronger FX, significantly lower interest rates, booming credit and non-traded inflation pressure, and a marked deterioration in current accounts. Part of China’s growth downshift is linked to structural forces, but the credit problems that have been in focus recently also stem from the aftermath of the late-2008 shock.
Now that the US housing market has turned the corner, a positive US impulse is bringing about the reverse adjustment and higher rates (Exhibit 2). But the reversal is likely to be harder, as capital inflows retrace more quickly and also because the starting point is more challenging. EM current accounts have deteriorated to their weakest levels in years, credit has boomed, inflation has remained above-target, currencies are too strong and interest rates are too low. Moreover, as we have highlighted elsewhere, EM economies and assets have benefited from a number of tailwinds over the past decade (many of which were dependent on the impact of China’s high growth) that are likely to fade or even turn into headwinds. These include a progressive deterioration in the terms of trade for commodity exporters and an erosion of low inflation credibility. In that sense, these are ‘not your older brother’s emerging markets’ (see Global Economics Weekly 13/23).
Q. Given the size of the recent moves, is the pressure on EM assets mostly behind us?
Unfortunately, no. The normalisation of global rates has only just begun.
The twin headwinds from the post-housing-bust normalisation in the US and China growth downshift are likely to be around for some time to come (Exhibit 3). While we are a bit more optimistic about China’s cyclical picture in the near term, we have outlined the medium-term risks from their long credit boom (see The China credit conundrum, July 25, 2013). Furthermore, we doubt those risks will diminish markedly in the next few years. We also think that the process of US growth and rate normalisation is likely to be a dominant dynamic in the global economy for much of the next two or three years, with US 10-year yields steadily heading back towards a more normal level at a pace that may still be faster than the forwards discount. The flipside is that the rebalancing of demand, and the FX and rate adjustments this brings with it, still have a long way to go.
Even after the recent poor performance, most EM assets still do not look particularly ‘cheap’, although EM equities are closer to that point. This implies that our strategic view of the EM landscape is still quite cautious – as it has been since the start of this year – and we think we are in the middle of a rebuilding of risk premium in many places.
Our strongest conviction is that, on average, EM currencies – particularly in deficit countries and those with weaker institutions – will weaken further against the USD. But that in turn is likely to come with higher real (and nominal rates) in many places, as the declines of recent years reverse. We think that in this environment, EM sovereign (and, perhaps more obviously, corporate) credit spreads probably still need to widen more. In EM equities, which have underperformed since late 2010, there is likely to be lower downside than in other EM assets. Relative to the other asset classes, China’s growth dynamics may ultimately play the larger role, rather than the US rate adjustment (Exhibit 4). But given the pressure on EM rates, currency and credit, we still think the risk-reward in equities over the next year or two is higher in the US and DM in general than in EM.
Q. How far could these moves go?
Different approaches give different answers but all suggest the moves in FX, rates and credit can extend further.
Working out where various EM assets ‘belong’ or could move is a key challenge and something we plan to focus on more in this publication in the coming weeks. Different approaches give different answers. But they generally support the idea that there is still plenty of room in many places.
One simple way is to look at how much the shifts in EM currencies and rates have reversed either since the US housing market slowdown started in late 2005/early 2006 or since QE began in November 2008. Exhibit 5 shows the shifts in real trade-weighted currencies across EM since then. While there is a lot of variation, rates in many places are well below and currencies well above those levels.
This is a useful benchmark, but there is little to suggest that EM currencies were at the ‘right’ levels in 2005-06. We can focus instead on the kinds of currency adjustments that may be needed to accompany the narrowing of current accounts in some of the places where they have deteriorated most. Such exercises are quite sensitive to assumptions, but they generally show that quite large (20%-30%) TWI depreciations could ultimately be needed in many of those economies. By the same token, EM policy rates are on average around 200bp below where a US-style Taylor rule would set them given their output gap and inflation dynamics.
Benchmarking sovereign credit is harder. EM sovereigns have already decoupled substantially from the tight relationship that they held with US corporate credit through most of the post-2008 period. But even after the latest pressure, sovereigns are generally well below the levels seen in the periods of Euro area stress in 2011 and 2012. We think we are likely to see those levels again in the next year or two.
Q. Will it be another 1997-99-style EM crisis?
No, but different problems could surface instead, particularly if monetary tightening hurts domestic banks and corporates.
The recent sharp pressure on the IDR and INR in particular has brought back memories of the Asian and broader EM crises of 1997-99. In those cases, initial currency weakness led to a spiral of further currency declines, widespread corporate and banking stress, and deep recession.
The key question at this point in time is whether the currency depreciation that has already begun – and is needed – creates a feedback loop that turns out to be destabilising. In the Asian crisis and its aftermath the answer was a clear yes. The main reason was that companies and banks had taken advantage of currency pegs and low offshore interest rates to borrow short-term foreign currency abroad in large quantities. This meant not only that rollover risk was high. But currency weakness, once it began, destroyed corporate and bank balance sheets and crushed domestic spending, increasing the pressure for capital flight. With very high leverage rates, interest rate defence of the currency – when it ultimately came – also created serious private-sector pressure, which turned the defence into a double-edged sword.
This time, that dynamic is much harder to see (Exhibit 6). Foreign debt levels – including short-term debt – are much lower than they were then, current accounts in general are smaller and reserves are much larger. Only Ukraine runs a traditional peg, and even Turkey and Indonesia (which have lower reserve/debt ratios than many others) are well below the Asia crisis levels. Funding conditions may become more difficult for current account deficit countries, but the rollover risk is probably manageable. So the real question is whether there is an alternative story in which feedback loops set in, or whether currency weakness can be allowed to happen (perhaps alongside some modest restraint of domestic demand). There is more to be said about this, and we plan to expand on it in the coming weeks.
The most obvious channel through which this can occur is high inflation related to currency weakness. The risk is more acute in places where non-traded-sector inflation is already high, and where accepting currency weakness may erode inflation credibility further. The direct inflation impact of currency weakness should – in theory – be temporary, so for those with substantial output gaps and a below-target starting point, the pressure here should be absorbed. But in places such as India, Brazil, Indonesia and Turkey, inflation is already running above targets and above politically acceptable levels. In these countries, we are likely to see continued efforts at slowing the pace of depreciation with front-end tightening.
However, that response is not pain-free either. While it may succeed in stemming depreciation pressures – and the evidence suggests that decisive action is often needed – it could extract a heavy toll on domestic activity, moving market weakness instead to domestic corporate credits and equities in places where credit growth or leverage is high. And if investors sense a reluctance to go down this route for that reason, currency pressure itself may increase. So this could force some unpalatable choices, even without direct FX exposure on balance sheets, although the immediate risks would be to banks and corporates, not to sovereigns.
Q. What could stop the pressure in the coming weeks?
A dovish Fed, a more decisive EM policy response, and better China data would all help in different ways for different assets, although probably only temporarily.
Notwithstanding our structurally cautious view on EM assets, in light of the recent sharp moves a key question is whether to press the short view tactically or if a bout of relief is likely. Much of that comes down to assessing how much the two dynamics that have beleaguered EM lately are likely to be in play, aside from domestic policy responses in EMs themselves.
For the EM rates and FX universe, US rate relief is the most plausible relief valve. Our own views of the upcoming FOMC are on the more dovish side. We expect tapering – as does everyone else – but we also expect it to be accompanied with strengthened forward guidance. And although we are structurally bearish on US Treasuries this year, we are tactically neutral here. It is also possible that the path of US yields around the tapering announcement mirrors the experience of past QE announcements, i.e., a sell-off ahead of the announcement followed by stabilisation or even a modest rally after it. If this comes at or around the same time as the announcement of a new Fed Chairperson who is more dovish than expected, a period of stability in US yields could bail EMs out of the current round of pressure.
On the EM side, a much more decisive and credible tightening at the front end could also put a stop to the FX pressure. We have seen hikes in Indonesia and Brazil in the last two weeks, reserve policy in Turkey, and some fresh measures in India yesterday to boost foreign currency inflow. But if investors continue to sense a reticence to take more decisive action with policy rates, given the costs to the domestic economy, it may be hard to stop currencies from moving further. And the steepness of curves implies a high investor threshold for hawkish surprises. Overall, we still think the medium-term risk is for higher yields in the face of improving US growth and that it makes sense to keep duration short.
Somewhat better signs of data from China are arguably more risky for a blanket ‘EM short’ in the near term. So far, the shift on this front has been small (see Asia in Focus, September 3, 2013), but for the first time in several months the market’s view of China growth is improving. And although EM PMIs have not yet mirrored the improvement in DM PMIs, we think they will, to a degree, especially in countries such as Korea, Taiwan, Poland and China, which are most plugged into the global trade cycle. EM equities would be the most obvious beneficiary of that kind of cyclical shift, more than rates and credit. It is also possible that the same dynamic could see pressure on some China-sensitive currencies (the CLP, MYR and possibly the ZAR) ease temporarily. Despite our overall caution, we do think a period of better EM equity performance is now possible, like the one we saw in the last few months of 2012.
Q. How do risks vary by country?
Brazil, Turkey, South Africa, India, Indonesia face the largest challenges, but Thailand, Malaysia and Chile may also have some difficult adjustments ahead. The CE-3, Korea and Mexico look better positioned.
Brazil, Turkey, South Africa, India, Indonesia and Chile have been at the epicentre of pressure at different points in the summer on account of their current account deficits (Exhibit 7 and 8). This is likely to remain true. Given the adjustments globally that we have described, the biggest vulnerability is likely to come from those that a) need weaker currencies, b) already have inflationary pressures, c) have seen significant domestic demand and credit-related booms and d) have weaker institutional capacity.
Emerging markets with more solid current account dynamics are likely to outperform. Korea, the CE-3 and Mexico have (for varying reasons) managed domestic demand conservatively, with restrained import growth. Some of these are also most likely to benefit from their high exposure to G3 economies, and the continued signs of strength there.
Between the two extremes, there are countries whose fundamentals are better in a static sense, but that have deteriorated significantly as of late and could experience market pressures, particularly on their currencies. We think Thailand and Malaysia fall into this camp. Israel could also join the front-end tighteners if the ILS stops strengthening and policy makers focus on the stronger domestic housing and labour market picture.
Differentiation may not be a theme for all seasons. During broad and rapid EM sell-offs, we are unlikely to see assets rally in some countries. At best, we can look for KRW-like stability. During times of broader stabilisation, the weakest markets should continue trading at weak levels, while the better-placed ones should recover.
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