The blogosphere has been full of posts about angst over a possible U.S.-led attack on Syria. On that topic, I agree with Scott Grannis when he writes that it is likely to be a non-issue for the markets:
On balance, it would appear that the market today is saying that while the Syria issue is certainly something to worry about, it is not likely to have much of an impact on the economy.
We'll soon know if the market has correctly estimated the gravity of the Syria situation.
While there may be temporary market disruptions should the shooting start, the markets are priced in accordance with interest rates, earnings and growth outlook. Indeed, recent experience has shown that stock markets have tended to rally once the missiles fly.
EM tail risk rising
What I am concerned about is the re-emergence of tail-risk in the emerging markets. The Fed's QE tapering has signaled that risk premiums are likely to rise (see my previous post Regime shift = Volatility). The Fed's QE program was intended to push down Treasury, and later, MBS yields and to compress risk premiums in order to encourage market participants to take more risk and kick start economic growth. As the Fed signals that it is starting the process of unwinding this program, risk premiums are likely to rise.
In particular, the rise in risk premiums have hit emerging markets, hard. Consider this chart of the relative performance of the emerging market debt ETF (EMB) against U.S. junk bonds (HYG), sort of a measure of junk against junk. EMB has breached a critical relative support level and emerging market paper continues to weaken against U.S. junk. From a chartist's perspective, there appears to be no floor to this relative decline:
The risk-off/rising risk premium trade is also evidence in the carry trade of the major currencies as well:
The Fed washes its hands of the EM problem
Would emerging market turmoil affect the timing of a Federal Reserve to taper? The answer is no, according to this Bloomberg report:
Federal Reserve officials rebuffed international calls to take the threat of fallout in emerging markets into account when tapering U.S. monetary stimulus.
The risk that the Fed’s trimming of bond buying will hurt economies from India to Turkey by sparking an exodus of cash and higher borrowing costs was a dominant theme at the annual meeting of central bankers and economists in Jackson Hole, Wyoming, that ended Aug. 24. An index of emerging-market stocks last week fell 2.7 percent, the steepest in two months, compared with a 0.5 percent gain in the Standard & Poor’s 500 Index.
Such selloffs aren’t an issue for Fed officials who said their sole focus is the U.S. economy as they consider when to start reining in $85 billion of monthly asset purchases that have swelled the central bank’s balance sheet to $3.65 trillion. Even as the Fed officials advised emerging markets to protect themselves, they were pressed by the International Monetary Fund and Mexican central banker Agustin Carstens to spell out their intentions better in the interest of safeguarding global growth.
Stephen Roach wrote about how the Fed has washed its hands of the problem in EM-land [emphasis added]:
As the Fed attempts to exit from so-called quantitative easing (QE) – its unprecedented policy of massive purchases of long-term assets – many high-flying emerging economies suddenly find themselves in a vise. Currency and stock markets in India and Indonesia are plunging, with collateral damage evident in Brazil, South Africa, and Turkey.
The Fed insists that it is blameless – the same absurd position that it took in the aftermath of the Great Crisis of 2008-2009, when it maintained that its excessive monetary accommodation had nothing to do with the property and credit bubbles that nearly pushed the world into the abyss. It remains steeped in denial: Were it not for the interest-rate suppression that QE has imposed on developed countries since 2009, the search for yield would not have flooded emerging economies with short-term “hot” money.
A crumbling investment case for EM
The investment case for emerging markets was based on rapid growth led by exports, which leads to current account surpluses, accumulation of foreign exchange reserves and expansion of domestic credit. As the developed market economies growth has slowed, none of the aforementioned factors hold true anymore. The result has been negative fund flows out of many EM countries.
Roach echoed my analysis of how QE affected risk premiums and papered over the problems of current account deficits in emerging market countries:
According to the International Monetary Fund, India’s external deficit, for example, is likely to average 5% of GDP in 2012-2013, compared to 2.8% in 2008-2011. Similarly, Indonesia’s current-account deficit, at 3% of GDP in 2012-2013, represents an even sharper deterioration from surpluses that averaged 0.7% of GDP in 2008-2011. Comparable patterns are evident in Brazil, South Africa, and Turkey.
A large current-account deficit is a classic symptom of a pre-crisis economy living beyond its means – in effect, investing more than it is saving. The only way to sustain economic growth in the face of such an imbalance is to borrow surplus savings from abroad.
That is where QE came into play. It provided a surplus of yield-seeking capital from investors in developed countries, thereby allowing emerging economies to remain on high-growth trajectories. IMF research puts emerging markets’ cumulative capital inflows at close to $4 trillion since the onset of QE in 2009. Enticed by the siren song of a shortcut to rapid economic growth, these inflows lulled emerging-market countries into believing that their imbalances were sustainable, enabling them to avoid the discipline needed to put their economies on more stable and viable paths.
The prospect of a Fed QE taper has reversed flows:
The QE exit strategy, if the Fed ever summons the courage to pull it off, would do little more than redirect surplus liquidity from higher-yielding developing markets back to home markets. At present, with the Fed hinting at the first phase of the exit – the so-called QE taper – financial markets are already responding to expectations of reduced money creation and eventual increases in interest rates in the developed world.
He went on to warn:
Where this stops, nobody knows. That was the case in Asia in the late 1990’s, as well as in the US in 2009. But, with more than a dozen major crises hitting the world economy since the early 1980’s, there is no mistaking the message: imbalances are not sustainable, regardless of how hard central banks try to duck the consequences.
Bloomberg reported that Carmen Reinhart also warned about a panic in the emerging markets as hot money rushes for the exits:
“It could get very ugly,” Reinhart said today in a Bloomberg Television interview with Sara Eisen from the Federal Reserve’s annual conference in Jackson Hole, Wyoming. “Emerging markets had a capital flow bonanza lasting several years, the golden boom years, and the probability of a banking crisis, the probability of a currency crash, the probability of a default, all increase afterward.”
Watching for the EM Minsky Moment
With negative fund flows out of many emerging market countries, does this mean that we are likely to see a Minsky Moment and a repeat of the Asian Crisis in places like Brazil, Indonesia, India and Turkey?
I don't know, but there are several key indicators to watch. The first is the EMB/HYG ratio mentioned above. Another is CEW, the emerging market currency ETF. While CEW has been weakening, it is also testing a key technical support level. Let's see if it can hold at these levels.
As well, I am watching the relative performance of U.S. junk bonds to the Treasury market. So far, the U.S. credit markets have been unfazed by the problems in the EM countries. Should U.S. junk start to significantly underperform, however, it will be a sign that the global stresses are spilling over into the developed markets.
There will be lots of volatility in September. The most frequently cited reasons are Syria, the German elections, Friday's NFP release, the September FOMC tapering decision, the nomination of a new Fed Chair to replace Ben Bernanke and the debt ceiling debate in Washington. I believe that the greatest source of volatility will be the stresses in the emerging markets. There will be volatility. EM tail-risk is a key factor that we all need to keep an eye on.
Disclaimer: Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. (“Qwest”). The opinions and any recommendations expressed in the blog are those of the author and do not reflect the opinions and recommendations of Qwest. Qwest reviews Mr. Hui’s blog to ensure it is connected with Mr. Hui’s obligation to deal fairly, honestly and in good faith with the blog’s readers.”
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