EMERGING MARKETS ADAPT TO "NEW NORMAL" AS COMMODITIES CYCLE ENDS / THE FINANCIAL TIMES

October 5, 2014 10:13 am

 

Emerging markets adapt to ‘new normal’ as commodities cycle ends

 

By Jonathan Wheatley in London

 

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India addressed its current account by limiting gold imports and raising interest rates

Emerging market investors are in the grip of their third taper tantrum in 18 months. This time, however, “tantrum” – suggesting an all-consuming but shortlived emotional fit – may no longer be the right word.

What’s happening now is more akin to a lasting personality change as markets adapt to a “ new normal” resulting from what many think will be structural rather than cyclical changes in conditions.

“There are so many layers of complexity,” says Luis Costa, a currency and credit strategist at Citi. “A lot of investors out there still think of emerging markets from the perspective of the commodities cycle. But the commodities cycle is over.”

 

The demand from China that lifted commodity prices for a decade is a thing of the past. And with the shale revolution driving the US to “a multi-decade rebound in crude oil exports”, says Mr Costa, the global oil market is undergoing structural change that will keep oil prices low for years to come.

It is not only a matter of commodities. The end of the US Federal Reserve’s asset buying programme, the prospect of rising US interest rates and a strengthening dollar will have a lasting impact on the liquidity that has helped sustain EM asset prices.

 

At a country level, analysts say, many emerging markets that have relied on external demand for their commodities and other exports have failed to deliver productivity gains to drive growth at home and now face years of subpar performance. Researchers at the IMF recently warned that, overall, emerging markets would see GDP growth of about 5 per cent a year in future, down from 7 per cent before the global crisis.

Not all EM assets will suffer equally. When the first taper tantrum struck in May 2013, sparked by news that the Fed was about to taper its $85bn a month quantitative easing programme, an initial across-the-board sell-off was narrowed as investors targeted the most vulnerable markets. They concentrated on those with current account deficits and picked out a “fragile five” of Brazil, India, Indonesia, Turkey and South Africa.

 

Conditions have changed. By the time of the second tantrum, sparked in January by Argentina’s shock devaluation, India had addressed its current account by limiting gold imports and raising interest rates. Indonesia, too, had made progress.

 

Others have been less successful. Despite having raised interest rates, Brazil, Turkey and South Africa are still covering current account deficits with risky, short-term portfolio flows. Brazil also attracts more durable, direct investment but, like South Africa, is now exposed to the additional pressure of falling commodity prices. All three countries have been among the hardest hit since EM currencies began their latest sell-off in early September.

If lower commodity prices are the new normal, what about liquidity conditions? Some analysts point out that while the Fed is bringing quantitative easing to an end, the Bank of Japan is in full money-printing mode and the European Central Bank may soon follow.

Global liquidity, to be sure, is not about to disappear. But as Mirza Baig and Jasmine Poh of BNP Paribas put it in a note on Friday, “a printed euro (or yen) just doesn’t pack the same punch as a printed dollar”. The dollar is still the dominant global currency, and many EM investment mandates are in the hands of US-based fund managers with no option to switch their funding out of dollars into euros or yen.

They also identify a fundamental change in the relationship between global liquidity and the performance of EM assets. EM bond prices rose in tandem with global liquidity – measured by the combined balance sheets of the Fed, the BoJ and the ECB – from the global crisis until they fell with the Fed’s tapering announcement last year. Mr Baig and Ms Poh argue that bond prices should have fallen earlier, from the beginning of 2011, when commodity prices began to move down. But they were held aloft by QE, they argue; only when the end of QE was announced did they start to fall towards a new structural level.

 

Against this backdrop, the peculiarities of each market are coming out in high relief. Brazil’s failure to reignite growth has dismayed investors, who have been thrown into near panic by the prospect of President Dilma Rousseff being re-elected this month. The fall in the Russian rouble shows the impact of geopolitics – and perhaps give an advance warning of the effects of constrained dollar funding.

 

Mr Costa at Citi says that, so far, the strengthening dollar has not hit bond spreads in other EMs. But he and his team looked at recent episodes of dollar strength and found that, in three out of four, EM spreads did widen. “If the dollar run continues, [funding problems for EMs] could become much more significant,” he says.

How should investors react? Ilan Solot, EM currency strategist at Brown Brothers Harriman, lists three variables to look for: currencies that have levelled off after devaluation; low inflation; and large exports. Asian economies such as the Philippines, Malaysia and South Korea fit the bill.

Many emerging markets, though, face a future in which asset prices trade in a new, lower range: supported by the remains of global liquidity and constrained by slower growth.