UBS On Goldilocks Hope And Emerging Market Vulnerabilities

Tyler Durden's picture

A considerable area of investor concern rmains on emerging economies. As UBS' Larry Hatheway notes, the last thing that vulnerable emerging economies need at the moment is worries about a global growth slowdown, if that is indeed what is happening. That’s particularly true given that one of the relative few bright spots in the emerging complex of late was improved PMIs, reflecting some pickup in global manufacturing, exports and trade. While that lift might not help the down-trodden commodity producers within the emerging complex, it is helpful for the more manufacturing-oriented economies of Asia, selected parts of EMEA, or Latin America. But as Hatheway warns below, emerging vulnerability is about much more than just growth.

Emerging economy vulnerabilities (via UBS' Larry Hatheway)

It reflects the convergence of several challenges, including unsustainable increases in indebtedness (relative to GDP), current account deterioration, and the prospect of tighter global liquidity (and funding) conditions as the Fed proceeds with its tapering program.

The risks inherent in the emerging complex have been well documented. And to be sure, China is not the major concern. Recent attention-getting headlines about wobbly trusts are, of course, useful reminders of China’s overly rapid credit growth and misallocation of resources, but it is unlikely that a ‘trust bust’ heralds a growth-destabilizing credit event in China.

But when we turn to the ‘fragile five’ (and others with similar characteristics), we note considerable risks to emerging market asset returns, and potentially to global financial stability and growth.

Much has been made of the facts that current account deficit financing among emerging economies has been mainly via local currency-denominated portfolio inflows and that the countries in question have flexible monetary and exchange rate policies. Hence, a repeat of the Asian balance of payments crisis in its form and with its consequences (e.g., default on foreign currency liabilities) is less likely.

That’s correct, but those facts alone don’t ensure benign outcomes for either the countries at risk or for global capital markets. To begin, countries such as Turkey or South Africa, which have persistent large current account deficits, will have to reduce domestic spending relative to domestic output in order to return to more sustainable positions. Given limited potential for either a strong cyclical lift in the demand for their exports or for an autonomous increase in domestic output, domestic demand will have to slow to achieve a more sustainable external balance.

Growth can either slow gradually, with the help of the right policies or abruptly, via a sudden stop of foreign financing.

Some might argue that exchange rate depreciation can also facilitate the adjustment. Possibly, but the potential for currency depreciation is limited by several factors. First, domestic rates of inflation in the India, Brazil, Turkey or South Africa are relatively high. Weaker exchange rates will push up import prices. As a result, changes in real exchange rates are likely to be small. Second, and perhaps more worrisome, is the reality that reliance on local-currency portfolio inflows means that currency risk has shifted to the foreign holders of those assets. If they begin to get nervous about currency risk they may try to liquidate existing holdings and balk at financing prevailing current account deficits. In either case, moderate currency depreciation could become a rout. Domestic interest rates would spike, putting a sharp brake on growth. And that could lead to social and political unrest.

That’s why we struggle to agree with recent comments by some high-profile investors, extolling the valuation case for emerging equities (mostly) or local currency debt markets. Sure, emerging equity valuations are low. But investors are not looking for value alone. Their primary focus remains on earnings. And if big chunks of the emerging complex are likely to experience slower growth (as external demand remains sluggish and domestic demand softens), then profit margins and asset turnover will fail to impress. Equally, if emerging currencies wobble it will introduce greater volatility into dollar- (or euro-) denominated returns from local currency holding. As a result, ex ante emerging Sharpe ratios don’t look very attractive.

The implication is that a ‘Goldilocks’ scenario is required for emerging equity, bond and currency markets to outperform. Global growth will have to be strong enough to facilitate the required improvement in net exports, but not so strong as to elicit a re-think about the Fed’s gradual approach to monetary policy—one that would send bond yields higher and exacerbate current account financing. Goldilocks scenarios are, of course, very nice. But they aren’t terribly frequent or long-lasting.