Monday, December 16, 2019
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Fed leaves emerging markets out in the cold

What struggling emerging markets need right about now is a big sell-off — in the US. Without a substantial downdraft on Wall Street, the Federal Reserve is highly likely to carry on trimming the amount of bonds it buys every month, continuing at its meeting ending on Wednesday by taking it down another $10 billion (Dh36.7 billion) to $65 billion.

That tapering will accentuate pressure on emerging markets, which have suffered substantial losses on currencies and securities with investors increasingly less interested in discriminating between the weak and the more stable.

Weakness in emerging markets, and mixed US economic data, have driven US stocks down a somewhat paltry 4 per cent or so from recent highs. While that leaves Wall Street lower than it was when the Fed commenced its quantitative easing rollback in December, there is little reason to believe it will prompt the central bank to stage an abrupt about-face.

While that would immediately ease funding and market conditions for emerging markets, it would cost the Fed much in credibility, especially after it twice surprised investors in September and December about the timing of the taper.

Tapering is bad for emerging markets assets in exactly the opposite way the expansion of quantitative easing was good for them: it tightens the global supply of money seeking a better return, and sharpens investors’ focus on creditworthiness. That makes it harder for countries like South Africa, Turkey and India to attract the money they need.

All that leaves for emerging markets is the wan hope that the Fed will acknowledge, somehow, that tough times for emerging markets figure into their thinking.

“The Fed has stressed its view that what is good for the US is good for the world, but that convinces no one abroad and few domestically, so the only issue is whether the Fed can find wording that simultaneously expresses serious concerns on spillover risk and remains non-committal,” Steven Englander, a foreign exchange strategist at Citigroup in New York, wrote in a note to clients.

“Irrespective of the wording, if investors walk away thinking there is only rhetoric and little possibility of a Fed reaction, asset markets will sell off.”

The Fed does have a track record on this in one respect -tough trading in emerging markets over the summer partly drove a Wall Street fall that directly led to the September surprise in which tapering was delayed. Bond yields were actually rising over the summer, however, while in recent days they’ve been falling.

Though much has been made in recent years about the positive developments within emerging markets, a build-up of foreign currency reserves as a buffer and the development of new sources of funding, this emerging market sell-off is playing out pretty much like they used to in the old days. First the weakest wobble, but shortly the entire asset class is under pressure.

“Right now we are in full-blown financial contagion mode, and that means correlations have rushed towards the dreaded 100 per cent,” Benoit Anne, emerging market strategist at Societe Generale in London, wrote in a note to clients. “There is no point spending too much time trying to pick and choose when faced with a severe market crisis like the one we are witnessing in front of our screens. Right now, sell everything.”

That probably holds a lesson for investors in developed markets. The provision of massive amounts of liquidity by global central banks, especially the Federal Reserve, was done precisely to make investors become less discriminating about risks. That allowed emerging markets, particularly the weakest, enough time, or rope if you prefer, to restructure and reform.

Some did, notably, but many did not.

What happens in emerging markets is probably small enough not to drive global growth, but it is very likely similar to what will happen in developed markets as the Fed continues to remove stimulus.

There is plenty of evidence of excess in developed country credit markets and, as the taper continues, those companies and sectors, like housing, will come under stress. The key here is to watch US interest rates. When they rise, all manner of companies and investments, from highly leveraged borrowers to single-family rental homes, will look less sustainable.

We saw a bit of that sell-off over the summer in the US, and that is probably what caused the Fed to pause. If a risky asset sell-off, a sizeable one, starts in the US in coming months, it too, like emerging markets today, will prompt an indiscriminate tumble.

That could cause the Fed to pause or reverse the taper, but not in time to be much help to emerging markets.