The Euro area is no longer the centre of all the stress... EM countries are! Despite their significant correction in recent months, SocGen notes that valuations remain far more extreme (or cheap) and outflows are dominating (despite a 24% discount on a price-to-book basis across EM stocks, they reain rich historically). Significant structural issues like balance of payments, deficit or inflation may lead to further turmoil in emerging markets, potentially destabilising the underlying economies.
Via Societe Generale,
Epicentre of the crisis is moving towards EM Countries
We read history in a simple way.
In 2007/08, what was supposed to be a liquidity crisis at the beginning finally switched into a full blown financial and economic crisis centred in the US. Since 2008, the US has climbed a wall of worries, allowing US assets (both bonds and equities) to outperform.
In the period 2009/mid-2012, the epicentre of the crisis switched to the eurozone, where a mix of bad governance and structural weaknesses led to bailouts and recession. Eurozone assets (except in Germany) are today where the US assets were in 2009, ready to “climb their wall of worries”, with significantly improved governance and an improving growth outlook.
Since 2013, signs of weaknesses have appeared in the EM World, burdened by the prospect of a tighter US monetary policy (read: higher USD) and huge outflows. Significant structural issues like balance of payments, deficit or inflation may lead to further turmoil in emerging markets, potentially destabilising the underlying economies.
When the liquidity tide turns, EM assets are hurt
Recent outflows from EM assets: minor compared to previous inflows
EM assets (both bonds and equities) have suffered strong outflows this year. However, these outflows remain minor compared to cumulative inflows over the last 5 years. So potentially, much more outflows should be expected when the Fed effectively tightens its policy.
When the liquidity support falls, all EM assets (FX, bonds, equities) suffer
The average correlation between EM equities, EM bonds and EM FX has strongly increased since Bernanke first signalled he was considering the tapering of asset purchases.
EM: some structural issues around
The bull story has turned sour in some emerging markets as external balances have deteriorated
Countries with a deteriorating external balance have seen their currencies depreciated strongly since 22 May (e.g. India).
On the contrary, South Korea has been relatively resilient.
EM currencies now fully floating
Compared to historical crises in EM countries, fewer and fewer EM currencies are directly pegged to the USD. While this may be a source of vulnerability in times of market turmoil, it has helped EM countries absorb external shocks more easily.
As always, the market will concentrate on the weakest countries, putting their currency under strong pressure and drying up liquidity.
Elections in sight likely to paralyse decision making for some months ahead
On top of the economic imbalances highlighted above, some EM countries risk paralysis in the coming quarter due to political events. Governments that seek to be re-elected will want to avoid policy tightening, increasing the risk of a market attack.
EM asset valuations have further to fall
EM bonds: spread (versus US Tresuries) is far from extreme and could widen further
Despite the strong correction of EM bonds (+44bp since May 2013), their valuation is far from extreme.
The EM bonds spread over US Treasuries has recently widened. Nevertheless, it remains far from last year’s level and could widen again.
EM equities: do not catch the falling knife yet!
EM equities started to correct in 2010, when they traded at a premium of around 20% relative to developed markets (as measured by the price to book value ratio).
We continue to stay away from EM equities (despite a 24% discount), as outflows are running at high levels.
EM equities and commodities: six versus half a dozen!
Commodity and EM equity cycles have been strongly synchronised over the last 15 years. They obviously have some common key drivers: Chinese demand, the liquidity factor and sensitivity to the USD.
Nevertheless, commodities have recently been more resilient, as many of them are getting close to their cost of production.