Fed actions hold key to EM rout

The rout in all things emerging markets-related has continued over the last week, and it is now becoming fairly indiscriminate as the risk-off mood even moves to US equities.  

Market turmoil reduces rate rise probability

Outflows from emerging market bond funds surged to an 86-week high. There is no shortage of things to worry about, as the Chinese stockmarket has also been sinking, falling by about 8.5% on Monday alone.  

The oil price continues to slide and the deflationary bias of price movements in general has accelerated. Two weeks ago we thought that there were no market prices suggesting that the Federal Reserve (Fed) could hike rates in an extended fashion. Last week market prices were raising doubts about the Fed’s ability to raise rates even once.

Probabilities of a September start to a rate hiking cycle are now substantially lower, according to market pricing.  We continue to believe even four rate hikes over the coming year would be an heroic outcome. While the Fed looks to normalize rates, markets are saying normal might be going out of the window.

In markets like these we look for signposts—observable data instead of emotionally-loaded forecasts. We make no argument here for buying emerging markets this minute, but we do offer some perspective.

The first thing you want to see is fundamental improvement on the ground, because as selling increases in intensity that improvement becomes a necessary, but certainly not sufficient, bulwark against further price collapses. 

What's happening in emerging market debt markets?

There are unmistakable signs that the rout in emerging market currencies is shrinking external deficits, a precursor to improvement. Let’s look at the “fragile five”, who moved into the spotlight during the 2013 “taper tantrum”. As compared to a year ago, the current account deficit in Brazil has been positive for seven straight months, in Indonesia for two consecutive quarters, in India for five out of seven quarters since the taper tantrum, in Turkey for six straight quarters, and in South Africa for six of the last seven quarters. Currencies are notoriously difficult to value for markets and for academics looking for what is “fair”, but a reasonable rule of thumb for a simple investor is to ask whether the value leads to relatively balanced accounts.  And we are getting there in the largest countries with the biggest external deficits.

Are valuations in emerging market debt extreme?  Not yet, for large parts of the market.  However, consistent with the standard emerging market playbook, liquid high-quality sovereign debt is the first piece thrown off the boat as outflows are recorded. So, investment grade sovereign spreads to Treasuries are now wider than they have been for 98% of the last five years (which includes the euro crisis of 2011).  Even most of non-investment grade tells the same story.  Sure, we can go wider but if you had to lock away your money for two years and never look at a computer screen, history tells you there is a very high probability you would be pleased with what you saw at the end of those two years.

What needs to happen?  

Critically, reserve levels need to stabilize. The popular press made much last week of the removal of the currency peg in Kazakhstan, and the subsequent 25% devaluation.  But that is a cleansing that needs to occur and we expect others, like Nigeria, to follow suit.  Dollar bonds for Kazakhstan—a solid credit we are happy to own—initially dropped two points before quickly returning to unchanged, as the market concluded that the move represented an improvement in credit quality, not a reason to panic.  

We expect larger policy responses to begin to happen. If there were any doubt only a few days ago, there should be none at all now - that even incrementally more restrictive monetary policy by the Fed is a danger in a very slow growth world. When the Fed openly acknowledges that fact, it may represent the end of the turmoil for emerging markets.