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Why emerging markets have spooked investors
We explain why worries over emerging markets have sent global stock markets spiralling lower.
by Chris Marshall on Feb 04, 2014 at 15:36Follow @cmarshallCW
What’s wrong with emerging markets and are they to blame for the global stock market declines so far in 2014?
Many investors will be mulling those questions as shares around the world fall. Britain’s FTSE 100, the benchmark index including corporate giants like BP and Shell, has dropped on 9 out of the past 10 days. It lost 3.5% of its value in January.
That poor start to the year – reflected to differing degrees on all major world share indices – contrasts with the cheery Christmas consensus among commentators for another decent year for shares, albeit not matching 2013 (when the FTSE 100 rose 14%).
The reasons for the sudden declines aren’t totally clear cut. Nor are they necessarily new; after all, so-called emerging markets have been out of favour for a few years with investors who have found better returns in places like Japan and the US. Shares in emerging markets have hardly budged over the past few years even as developed world indices have soared higher. But several things happened at once and at a time when investors were already questioning whether a setback – or ‘correction’ – was due after such strong gains.
China is certainly partly to blame. It is well known that the economy is no longer able to grow 10% a year, but what is not clear is whether a controlled slowdown can be achieved by the authorities. It has been a rocky ride and every data point is closely scrutinised. A Chinese ‘hard landing’ – a fuzzy term equating with annual growth of lower than 7% – is generally deemed the biggest threat to global markets, having superseded a break-up of the Eurozone and US budgetary issues.
Any weak report on China’s economy – or at least one that doesn’t meet the expectations of economists polled by organisations like Reuters or Bloomberg – is enough to hit financial markets around the world. A typical reaction is for shares in resources companies listed in London to fall, and the overall FTSE 100 with them. More recently, other companies targeting growth in China and other emerging markets, such as asset management firms and consumer goods companies have responded badly to such news.
So a report published nearly two weeks ago showing that China factory growth fell in January for the first time since July is largely deemed to be the trigger for the recent rout.
A couple of days later some separate news from China added to investor angst: the news that a so-called ‘trust’ company had only narrowly avoided a default. These products, which are not to be confused with the UK’s investment trusts, use investors’ money to provide finance to Chinese companies (in return for juicy yields). They’re part of the country’s ‘shadow banking’ market that provides financing outside the country’s banks – an opaque sector that has swollen on possibly dubious loans and a lack of regulation.
Behind all of this emerging market action though was a bigger player: the US Federal Reserve. The central bank started scaling back its stimulus scheme in December, reducing the amount of money it splashes out on bonds each month by $10 billion (£6 billion) to $75 billion (£46 billion).
Much of that money from what is called 'quantitative easing' (QE) has ultimately flown to emerging markets in search of higher returns. Investors have long known that ending this bond-buying programme would be painful for emerging markets as the money could flow in the other direction, back to the US.
Another cut to the Fed’s aid programme was expected in January, and the central bank was forthcoming. These events are surrounded by anticipation, and volatility: a ‘taper’ tantrum it has been called.
Equally though, it could have been assumed that the so-called ‘tapering’ of the stimulus scheme was anticipated by global markets, which tend to be way ahead of the economy or policymakers’ decisions.
The reduction in Fed stimulus means money moves out of emerging market currencies. This is where the serious action has been in recent weeks, with emerging market currencies plummeting. While not garnering as many headlines as shares, or equities, the foreign exchange (FX) market is the biggest in the world and critical for all investors.
Currency declines make imports into emerging markets more expensive and worsen the often already high inflation in these countries. That's why countries like India, Turkey and South Africa raised interest rates last week in a bid to keep the hot foreign money in their borders. But unfortunately it wasn’t enough to curb the outflows or stem the currency rout.
At the centre of emerging market FX volatility has been long-suffering Argentina.
The Argentine peso has been one of the most volatile financial assets in recent weeks. It was rocked by a sudden decision from Argentine president Cristina Fernandez de Kirchner to relax restrictions on Argentines’ purchases of US dollars, considered a relative safe haven. That decision happened to coincide with China's disappointing economic data.
Meanwhile Turkey, not long ago an investment darling of the emerging market world, has faced its own problems. Investors started the New Year catching up on a domestic political crisis that had worsened in Turkey over the festive period. Turkey, they won’t have forgotten, is a county that is particularly vulnerable to hot cash flows, so the tapering of US QE matters.
Fragile and vulnerable
In fact Turkey is an unlucky member of the ‘Fragile 5’, alongside India, Indonesia, South Africa and Brazil. You see, where solid names like BRIC were once the thing in financial markets, we now have acronyms synonymous with vulnerability.
It hasn’t helped that apart from Turkey all of the ‘fragile’ quintet are holding national elections this year. Elections mean financial market uncertainty and probably a pause on the reforms that all of these countries so desperately need.
Bloodied but more grown up
Some of the more gloomy financial analysts, among them Nobel Prize-winning economist Paul Krugman, point out that the intervals between between emerging markets crises are getting shorter.
But others argue that their fragility shouldn’t be overstated, and that many of these countries have matured significantly. While raising interest rates may not have seen off the stock market sellers, these countries still have more tools at their disposal. They have large foreign exchange reserves that they can use to prevent currencies from weakening sharply. Some of the debilitating features of the past are gone, including fixed currency regimes, while markets are deeper and more liquid.
What’s more, it can be argued, the rate hikes from Turkey et al show that they’re ready and willing to act.
But then, once markets get the bit between their teeth, some of these issues get forgotten.
No one doubts the long-term investment potential of emerging markets. And many investors will be looking to pick up investments at knock-down prices, following the old stock market adage of buying when there is blood on the streets.
But it might be wise to wait a little while longer, even at the risk of losing some of the early gains. As Eric Verleyen, chief investment officer at wealth management firm SGPB Hambros, says: ‘There might be a time to buy ahead of us, but at this stage we prefer not to catch a falling knife.’
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