As the emerging world continues to wrestle with a by now familiar set of problems including falling commodity prices, a decelerating China, the threat of a Fed hike, and, importantly, idiosyncratic political risks, the attendant underperformance might well lead you to wonder if this is perhaps “the time for courage” (to borrow a Gartman-ism).
In other words, some might be thinking that now is the time to BTFD in either EM FX, equities, or credit.
Of course we would note that as bad as the picture is now - and it’s pretty bad - things can always, always get worse especially given the fact that two EM darlings and one key emerging Asia nation all face intractable political crises, a situation which increases the potential for some manner of black swan or tail event to come calling.
As a reminder, Brazil needs desperately to find some kind of (lasting) compromise between President Dilma Rousseff and house speaker Eduardo Cunha lest the government’s utter inability to negotiate on budget reforms should end up shattering any last vestige of confidence the market might have in the country.
Meanwhile, Turkey is mired in a civil war of its own making and protracted periods of violence, terrorism, and ethnic feuding simply can’t coexist with a strong economy forever.
Finally, in Malaysia, PM Najib is at risk of seeing his career and legacy crumble before his very eyes as he struggles to explain how $700 million from the country’s embattled development fund ended up in his personal bank account.
We mention those examples because the BRL, the TRY, and the MYR have performed miserably, but as you can see from the above, the political risk factors are very real indeed which should give one pause before reaching out to catch the falling knife and which should also underscore the importance of making a concerted effort to understand the intersection between finance and politics before placing bets on a whim.
But make no mistake, at its most basic level, this is a story about the fundamentals and the fundamentals for EM are quite simply a disaster:
- Global growth and trade have entered a new era characterized by structural, endemic sluggishness
- Thanks to loose monetary policy that has kept capital markets wide open to otherwise insolvent producers and thanks also to anemic global demand, commodity prices aren’t likely to rebound anytime soon
- Because the Fed missed its window to hike, both a hawkish and a dovish Fed are likely precipitate capital outflows
As it turns out, HSBC went looking for opportunities across EM and came to the same conclusions.
First, we have the five reasons for EM malaise:
These are, in brief: collapse in global trade cycle, competitiveness problems (rising manufacturing unit labour costs), faltering domestic demand, downside risks posed by China, and the slump in commodity prices.
And this is leading directly to a convergence of DM and EM growth, but not because DM is performing well:
The growth differential between EM and DM is still narrowing, not necessarily because DM is doing well but because EM is performing miserably. The leading indicators do not suggest any imminent improvement, either.
That’s not the only place we’re seeing a “convergence” between EM and DM - they are also starting to look alike in terms of leverage:
The situation becomes even more toxic when the EM leverage cycle is taken into account. Thanks to years of abundant and cheap external liquidity, EM has built up debt very rapidly, while the drivers of economic growth have shifted towards private sector (household and corporate) credit.
In many ways, EM is showing similar symptoms to its DM counterparts of weak economic performance and over- reliance on credit. The outcome is what we call the three EM debacles: de-leveraging, depreciation (or devaluation even de-pegging) and downgrades of credit ratings.
And now that the Fed has missed its window and, on top of that, changed its reaction function, uncertainty around the FOMC is greater than ever.
The external environment was already unhelpful with a very weak global trade cycle, erratic capital flows – and recently mostly outflows – and the risks surrounding the Chinese economy. On top, there is now another layer of uncertainty relating to the Fed, which has been telegraphing the message of lift-off in 2015 throughout the year, only to see the markets constantly pricing out the possibility of the first hike, not to mention the loss of momentum recently in the US economy. Fed monetary policy and its communication is becoming increasingly a source of uncertainty.
The takeaway: "In sum, this is a precarious environment, and we do not recommend taking risky positions in the EM space."
So coming full circle to our intro, this is, to quote the incomparable Gartman, "not the time for courage"...