The tough test of emerging markets | Financial Time

Hello. A hard day this Monday. Soaring energy prices seem to have caused one of our regular stagflation crises. Long-term growing “Faang” stocks were hit harder than the broader market, small-cap stocks fell less than the Nasdaq, and bond yields rose. It’s a familiar pattern now. But to see the real pain, look across the United States. Please send me the email: robert.armstrong@ft.com

A dark day for emerging market investors

Investors in developed countries are worried. Economic growth is slowing and inflation is painfully sustained. Central banks have little choice but to remain vigilant in the face of monetary tightening or lose control. Many people think central bankers need to get to work faster. The combination of a hawkish atmosphere and slower growth with risky asset valuations destabilized financial markets.

But while the threat of stagflation is troublesome in developed countries, it can be disastrous in developing countries.

Of course, emerging markets are foreign. However, many of them have some common economic vulnerabilities. Emerging market consumer price index baskets are heavily weighted by fluctuating (and correlated) food and energy prices. For this reason, and because of inflation concerns in the past, emerging market central banks need to be much more responsive in order to maintain their credibility and keep inflation under control. And as central banks in advanced economies tighten, emerging currencies weaken, inflation worsens, and capital inflows either decline or reverse. Oddly enough, in emerging markets, the most dominant financial factor is the US Federal Reserve.

At this point, there is good news for emerging countries, from Russia to Nigeria, which export energy. But for energy importers such as Turkey, India and China, recent high energy prices pose an additional burden.

Many central banks in emerging markets are aware of the nettles and rate tightening. Russia has cut interest rates from 4.25% to 6.75% this year. Brazil, 2 percent to 6.25 percent. And Mexico, from 4% to 4.75%. Other countries like Turkey and South Africa are slowing down. Here are some charts of the major emerging market currencies against the dollar over the past month from the Bloomberg terminal.

Russia (yellow) has the most hawkish policies and sells energy. This currency is hanging there. South Africa (white) left interest rates unchanged, while Turkey (red) lowered interest rates. SurprisinglyThese currencies are overwritten. Brazil and Mexico (purple and green) do not seem crowded enough to satisfy the market.

Luis Costa, Citi’s emerging markets strategist, calls this the “real bite” time for emerging market investors.

“It’s a very harsh environment. Inflation can be stubborn and growth expectations are down. It’s not stagflation, it’s a stagflation-like environment for EM. EM Assets Classes (equities, currencies, debt) are based on an important assumption. You depend on growth. Emerging investors love growth. So it’s a problem for the banks to go hiking. East: Brazil, Hungary, Mexico. But it’s probably inevitable [what] Components [CPI] basket [in those countries] Do: Look at the energy, look at the work. .. .. Growth prospects are not encouraging and not in the second half of 2020, so it is very difficult for central banks, but they may still have to recover more quickly. We cannot afford to lose control of inflation. ”

The deterioration in the performance of fixed income and emerging market equities over the past month is revealing.

They are told to invest in the sound of cannons, cannons are booming in EM. The EM strategist I spoke to agreed. not yet. City Costa said:

“Many term premiums are in the process of being set up [in EM bonds] Investors may benefit from this in the future, but keep in mind that this may not be the end of the readjustment. ”

Here’s Evans from Simon Quijano-Gemcorp:

“For local currency assets, it is definitely time to clarify. This is why central banks stock up in advance. [US] Conical. You have higher inflation that comes from energy, and it goes to food. This is a double blow from the Fed’s cut and regional inflation. There is no local currency anywhere [investor] want to become. “

Quijano-Evans is looking for an entry point, but it is currently barely visible.

According to Ed Al-Husiny of Columbia Threadneedle, the strategy for the coming months is to stay closer to countries where central banks are struggling hard against inflation.

“You can put the EM world in two buckets. One is really tight and the other makes it easier. So, on the one hand, Russia, and to a lesser extent Brazil. Meanwhile, Mexico, South Africa and Turkey. This last group [in big trouble], They are mostly offside. NOT. [Mexican] With pesos [South African] The land was destroyed this week. .. .. If, as a central bank of emerging countries, you talk about temporary inflation and fixed expectations, you are wrong. What if you neglect inflation and the Fed adds more inflation by weakening your currency? Sold by the owner of the bond. Buy an adult in the room. It is a real test of the credibility of these central banks. “

Quijano-Evans graphically represents the concept of “adults in a room”. This is the central bank’s real policy rate (key rate minus expected inflation) compared to each country’s “basic balance” (current account deficit and foreign direct investment, a measure of the dollar’s vulnerability to fluctuations). )is. Note Russia towards the upper right corner:

For the United States, from an economic point of view Pandemic It was offset by the first vaccine deployments and large-scale fiscal stimulus measures. Many emerging markets have limited access to vaccines, most of them lack a significant fiscal capacity to stimulate and currently face the potential of US monetary tightening. To sum up Al-Hussainy:

“Think of an alternate universe where Covid has not happened. EM maintained its orbit in 2018-19, but think about what it will look like in the next five years. Growth is declining significantly. .. .. Last year, there were still emerging countries with a lot of debt, weak growth and rising interest rates. There will be some pain for bond investors. “

A good read

My old friend and fierce rival John Ozers Solid housing Yesterday, “stag” stagflation is much less worrying than “flation”.