Emerging market currencies should outperform if the US enters a modest slowdown, investors have told Emerging Markets. But portfolio strategies are on hold for now, as fund managers wait to see the effects of the Federal Reserve’s response to recent turmoil in credit markets.
Mark Dow, portfolio manager at hedge fund Pharo Management in New York, cautioned against inferring too much about the real economy from recent severe financial market movements. Instead, overleveraged exposure to mortgage-backed securities and CDOs had forced funds to liquidate large positions into a shallow market of buyers, on the back of even relatively small rises in mortgage default rates.
"This financial crisis can be disconnected from the real economy, or it can contaminate the real economy. The Fed has made a sharp distinction between the financial and real economies, and is hoping that confidence will be restored so things will be limited to a financial volatility storm," Dow told Emerging Markets.
He believes this analysis is likely to prove correct, given that US companies are still running relatively lean operations, having been cautious since 2002 in hiring new staff or making new capital expenditures. But Dow acknowledged that for now he had to take "an agnostic view" as an investor, because the actual outcome is finely balanced with risks weighted to the downside, and could be a function of overall sentiment.
"The Fed cannot save the market from itself." The US monetary authority is widely expected to cut its benchmark interest rate by 25 basis points at its next policy meeting on September 18.
If the US manages a soft landing, Dow does not expect it to hit emerging markets too hard. A more persistent rise in risk aversion would provoke investors to exit, however, despite strong economic fundamentals and healthy corporate balance sheets in emerging markets at present.
"If there are more big liquidations, we would be especially concerned about the most crowded trades, like Brazilian, Turkish and some Asian equities. But a lot of the local currency debt is not quite as crowded," said Dow.
Arnab Das, head of emerging market research at Dresdner Kleinwort in London, also believes that emerging markets could weather a moderate US slowdown much better than during previous periods of financial turbulence.
"For the first time in living memory, every major EM economy is a net creditor, primarily to the United States - the locus of the original credit problem," said Das. This will help them protect their growth from real economic fallout in the G7, he argued, "in all but the very worst economic scenarios."
Stephen Gilmore, new markets currency strategist at Banque AIG in London, told Emerging Markets that taken as a whole, the emerging market foreign exchange asset class had already proven relatively resilient in recent weeks, with lower losses than developed market equities.
"The high-yield currencies have sold off as carry trades unwind, but funding currencies like the Czech koruna and Israeli shekel have held up well," said Gilmore.
By contrast, the emerging markets component of the MSCI equity index had been badly hit, and the performance of macro hedge funds was even worse, presumably due to forced deleveraging that prevented them from riding the mild rebound seen last week.
In response to a question from Emerging Markets, IMF deputy external relations director Gerry Rice said it was too soon to speculate whether any emerging sovereigns would need financial assistance from the Fund if global capital markets remained turbulent for a prolonged period. He reiterated IMF managing director Rodrigo de Rato’s view that emerging economies should hold up well in any case.
But Gilmore at AIG, a former IMF economist, felt that the financial channel would continue to remain more significant for emerging market currencies than economic developments, despite the risk of lower exports to the US.
(For more on local market investing, please see "Savvy investors step up emerging market exposure").