3rd September 2014
Jan Dehn, head of research at Ashmore discusses the resilience of emerging markets and why developed markets are sustained by deliberate policies of asset price inflation instead of reforms below.
Last year Emerging Markets (EM) clocked up 4.7% growth despite a 200 basis point rise on average in their borrowing costs (according to JP Morgan’s GBI-EM GD local currency government bond index) and the largest outflow since the Lehman crisis. If developed economies had experienced a similar tightening of their financial conditions it would have been extremely damaging, bordering on catastrophic, in our view. Therein lies the most salutary lesson of the past year:
When former Fed Chairman Ben Bernanke announced tapering in May 2013 he inflicted a major shock on financial markets, impacting both developed and emerging markets, both in terms of fundamentals and asset prices. The effects on asset prices are of course familiar: the US treasury curve re-priced 100bps, EM sovereign borrowing costs rose by a whopping 200bps from 5.25% to 7.25%, and one third of all US mutual fund holdings in EM local markets were sold. This was the largest outflow since 2008/2009.
A year down the road, we can assess how these market moves impacted fundamentals in developed and emerging markets economies. Did the subsequent economic performance justify how the market traded at the time of the shock? More importantly, what did we learn about what financial tightening might do to economies and policy choices going forward?
The first observation is that Emerging Markets fundamentals were far more robust than last year’s price action – and the hysterical media coverage that accompanied it – would have suggested. Last year Emerging Markets grew 4.7% in real GDP terms, which is actually 0.1% higher than the average growth rate from 1980-2013. The sell-off from May 2013 to January 2014 did not cause a single sovereign default, no country ran out of FX reserves, China did not have a hard landing, and the ‘Fragile Five’ quickly turned into the ‘Frugal Five’. The level of corporate defaults rose temporarily, it has since fallen and in any case the temporary increase in defaults was unrelated to anything that happened in the US treasury market. A small number of EM countries with self-inflicted cyclical challenges came under pressure, but quickly addressed their problems (mainly excessive demand). This year the IMF expects EM to grow about 4.9%, according to its April 2014 World Economic Outlook, though we think there is moderate downside risk to this forecast.
In short, there was no real fundamental story for EM in 2013 despite the violent market price action. Why then did markets sell? Partly there were technical reasons. Many investors had invested only very late in the recovery rally that followed the Greek default in Q3 2011. Speculative money had also tried to front-run illusory Japanese inflows.
But the more important reason is tragically familiar: Tapering was a new piece of uncertainty on the global horizon. Rather than try to work out how tapering might actually impact – or not impact as it happens – EM fundamentals, many investors instead simply reverted to the simple rule of thumb of buying something in America and selling something in EM. Banks, sensing the opportunity to cross some bonds, started to flog all kinds of misleading arguments about EM’s alleged fragility, while the media leapt on the opportunity to sell more papers.
A more sober assessment might conclude that developed markets fared less well than EM. Apart from the temporary and relatively short-lived 100bps rise in US treasury yields developed economies were largely spared a big shock last year. Yet, this 100bps move so damaged the US housing market that it prompted the Fed to abandon its attempt at tapering before the policy had even begun. When the Fed tried again in December the US economy soon fell into its weakest quarter of growth since 2008/2009 and now looks set to clock up another year of unexciting 2% growth. Europe’s growth rate also showed very little dynamism. The bounce-back from the European debt crisis was tepid – did not even reach a 1% real GDP growth rate – before it gave way to renewed weakness. The ECB is now rapidly moving towards yet more monetary stimulus. And Japan slumped to -6.8% qoq annualised growth in Q2 due to a single tax hike.
The lesson is salutary. Developed economies are in no shape to handle any serious monetary shock in our view. The policy responses across the heavily indebted developed economies have been to lift asset prices, but precious little has been done to reform the underlying economies and dealing with serious underlying imbalances and debt problems. Underneath the thin veneer of asset price inflation, developed economies remain extremely fragile. Their performance was – and is – wobbly. Going forward, one does wonder how developed economies will handle the enormous tightening challenge that faces them. One thing seems certain: tightening will be slow and very long drawn out. And inflation seems to be the only way out of the debt.