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By Anthony Harrington

It's a topsy turvy world when bad news is good news for emerging markets (EM). The logical expectation for the performance of EM in the face of the U.S. government shutdown (a piece of political foolishness of mammoth proportions) would be that they would plunge as the U.S. government grinding to a halt roils world markets. Instead they bounced, with two of the worst performers, Indonesia and the Philippines seeing the largest upward spike. Why?

The answer is simple. Given the political stalemate in Washington, the expectation is that the U.S. Federal Reserve will have no option other than to maintain its "loose for longer" policy and perhaps even step up its bond purchasing program to provide a temporary boost to the U.S. economy. This is why U.S. and European stocks bounced on the shutdown news and why emerging markets have come out to play. Naturally, the EM countries that were most affected and whose currencies plunged the furthest when the Fed began to talk up tapering (i.e., the "tapered" ending of its third quantitative easing program) are those that stand to benefit the most from this respite -- at least in the short term.

The Financial Times quotes a note from Societe Generale to its clients:

To the extent that it may affect Fed policy expectations this [the shutdown] may actually feed through as a risk-on signal for global emerging markets (GEM). In addition, this may lead to a downgrade of U.S. macro data in terms of market significance, which helps support the bottom-up approach to GEM while undermining the U.S.-centric top-down theme.

The Financial Times' plain English translation of this is that, instead of spooking markets, the first shutdown of the U.S. government in 17 years has caused investors -- smart, forward-thinking types that they are -- to speculate that the Fed will have no choice other than to go loose for longer to, as the Financial Times puts it, "mitigate the financial damage." Benchmark indices in Manila and Jakarta rose 2.15% and 1.3% in 24 hours while the Hong Kong Hang Seng index was up 1.1%.

Emerging markets have some positives in their own right to put on the table to encourage investors in this "risk on" behavior. The HSBC purchasing managers index (PMI) for Indonesia for September edged above neutral, signalling renewed growth in production volumes, despite the fact that the contraction in exports accelerated to the fastest since February. Input costs and output charges both hit HSBC survey records but the increase from 48.5 in August to 50.2 in September, signalling a marginal improvement of business conditions in Indonesia. "The above 50.0 reading reflected upward movements recorded for four of the five sub-components (of the survey)." Output rose for the first time in three months, which is also encouraging.

However, commenting on the survey, Su Siam Lim, ASEAN Economist at HSBC had a warning for investors:

Manufacturing conditions improved in September, but we remain cautious. The PMI and output indices are only marginally above 50, while new orders continued to contract, reflecting that output rose only because firms were working through their work backlogs. Going forward, cooling domestic demand on the back of tightening policies by the central bank and government is likely to mean a further slowdown for the manufacturing sector. If Indonesia's external imbalances and inflation rates are to be reined in, slower economic growth is a necessary condition.

Taking Lim's comments into account, it would seem that investors are in danger of being a mite too clever in diving into EM stocks on the back of the shutdown. This is still reasonably likely to end badly.

Source: Emerging Markets Get A Contrarian Bounce From U.S. Shutdown