This is an updated version of the article published in Le Jeudi (Luxembourg) on 6 February 2014 and in Beleggers Belangen (Netherlands) on 11 February 2014. 

A sturdy ship is needed when sailing in choppy waters. This is the conclusion we can draw from the turmoil that hit several emerging markets earlier this year. There is no lack of explanations for what happened: Argentina, China (shadow banking fears), the political context (Turkey), and, most of all, the US Federal Reserve. Actually, recent events were merely one episode in a saga that began when Fed chairman Ben Bernanke started up the quantitative easing programme. Back then, foreign and US capital were making waves (in the ‘currency war’).

Since May 2013, the waves have subsided amid capital outflows and the need to raise official interest rates to slow the drop in currencies. Emerging markets then began to resemble a small boat buffeted by the huge waves created by the ‘God of the winds’, i.e. the Fed, thus triggering overvaluations and undervaluations of currencies and other financial assets. But this analysis is only partly accurate. Another cause lies in the structural imbalances, including current account deficits (India, Indonesia, South Africa, Turkey, etc.), high inflation (India, Turkey, and Brazil), and excessive debt (Malaysia). In the past, Western investors looked the other way when faced with these challenges, placing more emphasis on the search for yield than on selectiveness. But they are now taking a much closer look.

This shift in perspective seems overdone given the gradualism and transparency of US monetary policy, precisely to avoid making waves. There are two possible explanations for this seeming paradox. The first sees emerging markets as a victim of a classic speculative attack. Investors are pricing in the fact that, ultimately, rising US long bond yields will make it harder to finance external deficits. They are already demanding a higher risk premium, hence, the currency drops and interest rates are hiked. The second explanation is that the emerging markets crisis is masking a deeper malaise, i.e., investors fear that the tightening cycle has some unpleasant surprises in store, and, because of their acute exposure to shifts in capital flows, emerging markets are merely the first victim on a list that will soon include others.

In my view, the first explanation is closer to the mark, and although a conservative investor would understandably stay away from emerging markets outright, a more aggressive investor will, against a backdrop of attractive valuations, keep an eye out for positive catalysts, including receding inflation and current account deficits and stronger exports and earnings forecasts. In this respect, it is worth noting that both India and Indonesia have benefited from renewed investor interest on the back of a reduced external deficit and hopes that the upcoming elections will bring change in terms of economic policy.

The second explanation, i.e., a deeper malaise, is hard to support given the gradualism the Federal Reserve has shown. Those that adhere to it should keep in mind that a trigger would be needed for emerging market turmoil to spread to other asset classes (e.g., corporate bonds and equities). One such trigger could be more aggressive than expected US monetary tightening in reaction to a sharp acceleration in growth. Another would be a serious blow to the global economy brought on by a drop in emerging market imports. Both of these scenarios look unlikely to me.

In conclusion, through interest rate hikes and currency falls, the normalisation of US monetary policy has triggered an economic adjustment process that should lay the foundation for market rallies. This process will take time and investors need to be patient, especially as elections in countries such as India, Indonesia and Brazil will hinder the implementation of structural measures even though recent equity market behaviour shows that investors expect implementation to be swift once the elections are behind us.

 

William De Vijlder

Vice – Chairman of BNP Paribas Investment Partners