As turmoil in the world’s financial markets intensifies amid fears of a global credit crunch, sell-side analysts are questioning the accuracy of their previously bullish convictions that emerging market fundamentals are strong enough to withstand US subprime fallout. Danske Bank argues that the current sell-off is a healthy correction aided by the ongoing tightening of global monetary policy that will lead to a normalisation of risk pricing. “It seems likely that the current events are the first steps in this normalisation and a full-blown return to the goldilocks situation of the last few years with extremely high returns and low volatility will be difficult.” Danske notes positively how high volatility in the US stock market has not correlated with emerging FX markets. But it remains perplexed that as EM credit spreads have widened, EM currencies have not suffered relative to other high-risk asset classes. It cautions that if conditions continue to deteriorate, external balances pose the biggest threat to the EM credit story: “Turkey, South Africa, Hungary and Iceland will be most at risk, whereas the Emerging Asian markets, which mostly have strong external balances, could be a safe haven.”
Shanat Patel of Nomura, however, remains bullish: “While investors go into spasm and refuse to participate we are not overly concerned about the long term impact, although it is not going to help investor sentiment and could lead to further
weakness particularly in FX markets.”
RBC Capital Markets weighs in on the debate over whether external market technicals or EM internal fundamentals will be the key near-term EM driver. Because it is likely to take months before the economic damage of the sub-prime mess becomes clear, the bank remains cautious in the short term: “EM will likely trade with a weaker bias as month-end reporting for July kicks in and mark-to-market losses reinforce the ongoing re-pricing of risk. Global markets, EM inclusive, will remain extremely prone to high volatility amid news, comments and rumours relating to U.S. housing, bank CDO / high-yield loan exposure and hedge-fund busts.”
Standard Chartered agrees that the fall-out from the sub-prime crisis is likely to worsen before it gets better. “There could well be more bad news to come later this year and early in 2008 given the increased number of mortgage re-sets due. Bad news dragging on for this long could well lead to markets being much more reluctant to jump back in so quickly to the risky trades. It would make less sense to do so if there was a long established pattern of more bad news coming out.”
The bank fears that EM’s resilience to external shock is waning and a second round of contagion could spell disaster. In this context, it recommends that Brazil and Russia are low risk since they have sound economic policies, low leverage and current account support. In contrast, Mexico, Turkey, Colombia and Venezuela present a medium risk due to their reliance on US trade/financial flows. But, it argues that currency and local bond markets in South Africa and Argentina could come under pressure in a “sustained risk averse world.”
Fitch in its “Market Correction–Where Liquidity Matters” special report argues that the outlook for emerging sovereigns is still promising given that their exposure to capital market volatility is reduced: “By low levels of issuance of sovereign foreign currency debt sovereign borrowers have increased their share of local currency financing.” The concerns remain with those economies with large external imbalances and financing needs which “will still be more exposed to the current market shock and could see greater pressures on currencies and volatility in local asset markets.”