Story Of EM Decoupling Was Always Over-hyped

Emerging market equities have not had a congenial summer. Since Ben Bernanke, chairman of the Federal Reserve, broached the subject of tapering the Fed’s asset purchasing programme back in May, they have notably underperformed developed world equities. It looks suspiciously as though the emerging market growth story is tarnished.

The story was, in truth, over-hyped. The suggestion emerging markets could somehow decouple from the developed world and deliver self-sustaining high growth rates for the forseeable future was always a nonsense. With the developed world now experiencing mediocre sub-trend growth the nonsense has become palpable, most notably in Europe where the travails of the eurozone have hurt the emerging market economies of central and eastern Europe, together with Turkey.

Not only that: emerging markets other than China face the problem they cannot decouple from China either. As the new Chinese administration tries to rebalance the world’s second-largest economy away from excessive reliance on investment towards increased consumption, Asian manufacturers in Taiwan and Korea are feeling the heat. So, too, with commodity producers such as Australia. The decline from double digit Chinese growth rates to the current seven per cent combined with the risk of a hard landing means these trade linkages are becoming uncomfortable. The so-called commodity supercycle, driven substantially by China’s investment boom, is surely over.

With growth slowing down, supply side weaknesses in the Bric economies – Brazil, Russia, India and China – are becoming more apparent. Perhaps that is the chief thing that these otherwise utterly disparate economies have in common. Some also have cyclical problems. India, Indonesia and Turkey, for example, have been forced to tighten policy after their economies overheated in 2010-2011.

The market reaction to Mr Bernanke’s tapering statement was undoubtedly overdone. But the US economy is ahead of the developed world pack in terms of the strength of its admittedly subpar recovery and it still seems likely that emerging markets will have to cope with a stronger dollar and higher US interest rates in due course. This will be difficult for those that are reliant on external capital such as Brazil, India, South Africa and Turkey.

There has, then, been an important change in investor perceptions. Before May the assumption was still that the composition of global growth had shifted irrevocably in favour of the developing world. At the same time the huge accumulation of foreign exchange reserves since the Asian crisis in 1997-8 meant that the creditworthiness of emerging markets was greatly enhanced.

Yet today many larger developed world economies are expanding faster than their underlying potential growth rates, while most emerging markets are growing at below potential. For the first time in years developed world growth looks not so bad relative to developing world growth. At the same time, the rebalancing of the Chinese economy towards consumption probably signals the end of the long period of excessive reserve accumulation.

Developing countries have also been issuing record levels of international bonds. While the outstanding sums are not great in relation to growth potential, it is a reminder that financing of growth is becoming less stable just as some emerging market economies are suffering from balance of payments strains.

In market terms the buoyancy of emerging market equities before May was a tribute to Fed efforts to drive investors into risky assets. Shares were discounting an unrealistic estimate of potential earnings. In the long run emerging markets will grow faster than mature economies, but greater realism in valuations is welcome. Yet that still leaves investors with problems. One is that, as in the aftermath of the Lehman collapse, all quoted asset classes in May and June moved down in tandem so it became impossible once again to achieve portfolio diversification.

Another, as Ben Inker of fund manager GMO points out, is that the Fed has pulled down today’s return on cash and expectations of future cash returns. This has increased the attractiveness of everything other than cash. Nominal bonds, inflation linked bonds, commodities, credit, equities, real estate – everything has been bid up as a consequence of the very low expected returns on cash. And this gives today’s markets a vulnerability that has not existed through most of history.

Current valuations, adds Mr Inker, only make sense in the light of low expected cash rates. Remove that expectation, and every other asset becomes vulnerable to a fall in price, as a rising real discount rate hits values indiscriminately. In such circumstances, the only safe haven is cash. And the cost of holding cash while waiting for the return to tighter policy will be high. It is an unpalatable dilemma from which there is no easy escape.