Things are getting downright scary in emerging markets. Just ask Bill Gross:
Gross: Emerging Market currency debacle. Deflationary winds becoming stronger. Risk assets at risk.— Janus Capital (@JanusCapital) August 6, 2015
Or have a look at this week’s headlines:
- UK rate hike fears recede, emerging markets on edge
- EMERGING MARKETS-Currencies retreat on talk of a Fed rate hike
- Lost Decade in Emerging Markets: Investors Already Halfway There
- Some Greek Lessons for Emerging Markets
- Currencies in Freefall Handcuff Bankers From Chile to Colombia
And on, and on.
One particularly alarming case that we’ve been keen to document lately is that of Brazil which, you’ll recall, is "up shit creek without a paddle" both figuratively and literally. For one thing, as Goldman recently noted, there’s not a single period in over a decade "with a strictly-worse growth-inflation outcome than that of 2Q2015." In other words, "since 1Q2004 there has not been a single quarter in which we had simultaneously higher inflation and lower growth than during 2Q2015."
And here is what that looks like on a scale of 100 to -100 with 100 being "high growth, low inflation" and -100 being "stagflation nightmare":
This helps to explain why CDS spreads have blown out to post-crisis wides.
For those who favor a more qualitative approach to assessing an economy’s prospects, don’t forget that the Brazilian economy recently hit its metaphorical, and literal, bottom when AP reported that, with the Brazil Olympics of 2016 just about 1 year away, "athletes in next year's Summer Olympics here will be swimming and boating in waters so contaminated with human feces that they risk becoming violently ill and unable to compete in the games."
So that’s Brazil, and while not every EM country is coping with the worst stagflation in 11 years while simultaneously trying to explain away rivers of raw sewage to the Olympic Committee, the combination of slumping commodity prices and the threat of an imminent Fed liftoff are wreaking havoc across the space. Consider the following from Bloomberg for instance:
Central bankers in commodity-dependent Andes economies aren’t even considering interest-rate cuts to revive growth, even as prices for oil, copper and other raw materials collapse.
That’s because the deepening price slump is also dragging down currencies in Colombia and Chile -- a swoon that’s fanning inflation and tying policy makers’ hands. Fixed-income traders have now ratcheted up cost-of-living expectations for Colombia and Chile after their tenders sank more than 10 percent in the past three months.
"It’s causing a headache," Luis Oscar Herrera, the chief Andean region economist at BTG Pactual SA, said by telephone from Santiago. "All the Andean countries have headline and core inflation above their target ranges."
In an interview with local newspaper La Tercera published Sunday, Chile central bank President Rodrigo Vergara said rate cuts are completely off the table as the sinking peso fuels price acceleration. That’s even after Chile’s economy shrank 0.07 percent on a seasonally adjusted basis in the first five months of the year, buffeted by the nosedive in copper prices. Chile is the world’s biggest exporter of the metal, which has tumbled 26 percent in the past year.
In other words, central bankers are grappling with slumping export-driven economies and FX-pass through inflation or, more simply, bankers are caught between a "can’t cut to boost the economy" rock and a "can’t hike to tame inflation" hard place.
"Inflation [in Colombia] stood at a monthly 0.19% in July, a print above market consensus (0.11% MoM) and our forecast (0.15% MoM) [which] goes in-line with a materialization of the foreign exchange pass-through to inflation in a month where the COP depreciation against the USD stood at 10.9%," Citi said earlier this week, adding that "the transmission still looks small and this has prompted some analysts to consider that there is a delayed pass-through effect which should materialize in the months ahead." In other words: it’s about to get worse.
More broadly, "developing-nation currencies have fallen to their lowest levels since 1999, and bonds denominated in those currencies have wiped out five years’ worth of gains," Bloomberg notes.
Tying it all together, Morgan Stanley says that Brazil has taken "center stage as the great EM unwind takes hold." In short, "a triple unwind of EM credit, China’s leverage and easy US monetary policy" has tanked the space and although Morgan thinks we may be more than halfway through the cycle, the bank "remains wary of new risks, naturally."
Yes, "naturally," because this is the same Morgan Stanley which just two weeks ago predicted that based on the forward curve, the rebound in crude prices will be so bad as to have no parallel "in analysable history." Needless to say, that doesn’t bode well for commodity currencies and neither does a Fed rate hike. So in this environment, who is most exposed? Morgan Stanley endeavors to explain. Here’s more:
Who’s Most at Risk?
Brazil remains at the centre of the Great EM Unwind. Its salutary but now lukewarm macro adjustment implies a lower risk of a sharp and deep recession that could have turned the second derivative of growth positive sooner. A recession at home when Fed-related volatility shows up could create significant financial volatility.
Turkey and South Africa remain at risk because they have shown very little adjustment. Indonesia’s macro adjustment continues, particularly now, and this should continue to reduce its exposure and vulnerability.
Commodity exporters – particularly Russia and Colombia – remain under pressure, driving fundamentals weaker towards a possible change in their model of growth.
And here's the complete breakdown by risk factor:
But wait, there's more. The bigger picture problem (i.e. looking beyond the current downturn in commodities and the looming Fed hike) for EMs revolves around slumping global trade, a topic we've discussed at length (here, for instance). As WSJ notes, the downturn in trade which many had assumed was merely cyclical, may in fact be structural and endemic:
Central to this emerging-market slump is the unprecedented weakness of world trade, which has now grown by less than global output for the past four years, unique since World War II. Apart from a brief recovery in 2010, global trade volumes since the start of the global financial crisis have fallen well below the levels in the 1990s and early 2000s.
What is more, the boost to the global economy from trade has been weakening: A dollar of trade today delivers less than half the boost to global output that it did between 1986 and 2000, according to the World Bank. For emerging-market economies, which have historically been highly dependent on exports, this presents a major challenge.
Until recently, most investors assumed this slowdown was primarily cyclical and trade would pick up as developed markets in the U.S. and Europe recovered.
But it is now clear that there is also a significant structural element to the weakness in trade, reflecting changes in the global economy.
This structural shift in the pattern of global trade has profound implications for the economic models of many emerging markets. Trade has been one of the main engines of higher living standards. In the past, they could rely on currency devaluations to improve their competitiveness and help pull their economies out of the mire. But this time may be different: There may no longer be the demand for what they produce.
So where does all of this leave us? Well, that remains to be seen, but if we truly are in for a prolonged period of lackluster global demand and depressed trade, we could begin to see a wholesale shift in which the markets formerly known as "emerging" quickly descend into "frontier" status and after that, well, cue the "humanitarian aid" packages.