Getting twitchy? Spare a thought for EMs...

 

ref:- "Dark days for emerging market investors" , Unhedged newsletter in the Financial Times, by Robert Armstrong

 Pre-market futures trading points to a slightly stronger opening for US stocks, and many will be relieved that yesterday's dismal performance hasn't immediately spilled over into today. That's not to say it won't of course... it could be that the early action just represents a degree of bargain-hunting, and in light of yesterday it would be easy to ascribe Friday's more positive tone at the end of a difficult week as being driven by much the same thing.

The truth is that markets have been jittery almost since the last Fed meeting on Sept 22nd and Chairman's Powell's subsequent address that opened the door to a tapering of Fed asset purchases in November. The immediate reaction to Mr Powell's words was generally positive. All major central banks are being pushed towards some kind of tightening by inflation numbers that are proving a lot stronger, and almost certainly a lot less transitory, than had been hoped. In those circumstances, it was thought by most investors that Mr Powell had communicated the Fed's likely future path in a gentle enough fashion not to upset any apple-carts. But the great inflation scare continues to gain momentum, fired by a spike in oil and the energy complex as a whole, supply bottlenecks and labour shortages, and naturally encourages the more hawkish to call for stronger action from the Fed.

At the same time growth projections are being undermined by the same factors and the failure to get control of the Delta Covid variant. As Mr Armstrong points out, that leaves us with a background of hawkish noise regarding monetary policy, and slowing growth at a time when we know asset valuations are sky-high, historically speaking. No wonder people are getting nervous.

Everywhere you turn you will hear talk of Stagflation. Just to be clear, Stagflation is defined as a combination of high inflation, high unemployment and a stagnant (or contracting) economy. That is not where we are (yet), and hopefully not where we're headed but scare-mongering makes good headlines. The worry is that these things can be self-fulfilling, especially with inflation, and the sharp rise in the price of energy brings to mind (wrongly in our view) the sad stagflation period of the 1970s after OPEC ramped up the price of oil... all grist to the mill for the doomsayers.

Even the unrealised threat of stagflation is a real concern in developed markets, but it's much worse for emerging markets. We sometimes find it pretty unhelpful how nations with very different types of economies (commodity producing / industrial etc.) are lumped together under the EM banner, but Mr Armstrong is absolutely right to point out that they do share many of the same financial "vulnerabilities". 

EM nations use measures of inflation that are heavily weighted towards the most volatile elements of any basket of goods, particularly food and energy. Because of their long and sad record of failing to control inflation (something that has repeatedly eviscerated EM economies over the years), to maintain credibility their central banks have to be seen to be pro-active and agile in monetary policy to keep that beast in check. But if developed nations are forced to raise rates, that will inevitably weaken the currencies of EMs which both increases inflation and adversely affect the levels of capital inflows ... unless of course they keep raising their own interests rates, which may protect the currency but of course brings different financial hardships.

Plainly, those EMs that are oil producers (Russia, Nigeria etc.) are benefitting from what's going on in the world right now whilst oil importers such as Turkey, India and China are suffering but all have to be vigilant. To take two extremes: notwithstanding the benefit of oil price rises, Russia has raised rates from 4.25% to 6.75% this year, and the Rouble has gained about 3.5% against the Dollar; by contrast there's Turkey, ruled by President Erdogan... a man who plainly graduated from "The Earth Is Flat" School of Economics, believes that higher rates provoke higher inflation, and tends to sack any central bank Governor who thinks otherwise. The Turkish central bank shocked the markets by cutting rates two weeks ago, thereby exaggerating a move that has seen the Turkish Lira drop 20% of its value against the Dollar during 2021.

All central banks are facing a very difficult balancing act right now, their decisions on monetary policy having to weigh the quest for growth (easy monetary policy) with the need to keep a lid on inflation (tighter monetary policy). But in emerging markets that dilemma is particularly acute: investors in EMs value growth (why else would they go there?) almost as much as they hate inflation. Ramping up rates combats inflation, protects the currency and boosts the central bank's credibility but in the short-term damages prospects for growth and deters investment, cutting off the capital inflows that are so vital for any emerging nation. It's why EM equities and bonds have been suffering over the last month, and it's not clear why that should change anytime soon.

Of course, experienced EM traders are famous for spotting opportunities in areas and at times that few would consider, but none of the EM strategists Mr Armstrong talks to thinks that we're anywhere close to entry points... rather the opposite, in fact. There will come a time for reappraisal, and when it arrives we should be looking at those nations who have acted responsibly and swallowed the painful medicine required to keep the ship afloat. They're all likely to suffer a lot of hardship between then and now, but when Ed Al-Hussainy of Columbia Threadneedle says "Buy the adults in the room", these are the ones he's talking about... but not yet.