Downside Risk for Emerging Markets

 |  Includes: CEW, DEM, DGS, EDC, EDD, EDF, EDZ
by: Forex Traders

One important difference between a bull and a bear market lies in volatility. Rising markets are often accompanied by falling volatility, while bear markets are coupled to rising volatility in most cases.

The cause of this is not hard to determine: in a bull market traders feel more confident about holding an asset in the face of adverse shocks, as confidence in the economy itself reduces the amount of emotional buying and selling.

In a bear market the opposite happens. As buyers leave the market, liquidity is also reduced, which allows moderate amounts of new funds to create swings in either direction, giving the impression of an incipient bull market to some at times.

It is not hard to recognize the bull when it arrives, but it is a lot harder to be confident about a bear market because it is itself born out of uncertainty and lack of confidence. Many are mistaken into believing that a bear market is a downward ride with few upward movements of significance.

On the other hand, historic experience clearly shows that bear markets comprise some of the most bullish movements in history, due to their volatile nature.

The recent swings in the markets, the rally in emerging market stocks and bonds, the depreciation of the dollar, and the improvements in the credit markets should also be seen in the same light.

For a proper understanding of what is going on in the markets, we should place all the recent developments in the context of the events that have been occurring since 2007. Markets have come a long way down since then, several major bankruptcies have occurred, and unemployment has been climbing to double digit numbers all around the world. Interest rates are around 1 percent even in some emerging markets, an unprecedented phenomenon.

It is only natural, if only on psychological, and technical reasons, that such a long period of disastrous contraction will lead to a period of relative calm, which translates to rising markets due to the partial elimination of the fear factor that has been suppressing financial activity for such a long time.

But it is wrong to mistake this respite for a major improvement in the health of the economy.

In this context, emerging markets present a diverse, yet almost universally worrisome picture. In India the public budget deficit is likely to exceed 10 percent this year, as inflation (measured by PPI) slows to zero. In Indonesia the trade surplus has recently turned into a deficit. In Malaysia the government is engaging in a massive stimulus program, greatly increasing the budget deficit. In Thailand rates are down to 1 percent, as the export sector collapses, and GDP is expected to contract by 4 percent. In Turkey unemployment is at 15 percent, and the budget surplus has been erased by the government’s inefficient attempts at stimulating the economy. In Ukraine the economy may contract by 15 percent this year. In the Czech Republic and Slovakia, unemployment is clearly headed to double digit levels. Of course, the troubles of the Baltic region and the former Soviet Republics could merit an article by themselves.

In many of these nations, the health of the economy is increasingly dependent on external flows which depend on the risk perception of international investors. It is only a matter of time before the developing fundamental weaknesses of emerging markets are recognized by market participants.

In addition, we must consider the rising prospect of political instability: it is easy to keep everyone appeased in a land of bounty, but with the pie shrinking, the political climate will become increasingly harsher. All these factors do not bode well for the health of the developing world.

The ripple effects of a major market crisis reach developing nations in waves, and is felt fully only after the passage of some time. Many of these nations have banking sectors that are not heavily burdened by non-performing loans.

But the credit cycle develops slowly, and even in an extreme example such as Spain, the cumulative impact of a collapsing housing sector, rising unemployment, and contracting economic activity will only materialize fully after the passage of years.

In short, the risks are strongly on the downside for emerging economies, although markets are unwilling to recognize this fact at this stage.