Sell-side economists are debating whether the recent infusion of liquidity from central banks globally will help stabilise investor sentiment towards riskier EM assets. Standard Chartered believes that the jury is still out: “one wonders if the stabilization is a result of central bank measures or market fatigue - a mixture of both sounds reasonable.” It argues that investor sentiment is impossible to predict: while the Fed has appeared to allay falling confidence in the short-term lending system, it is unclear whether it has propped up risk appetite in general.
Standard Chartered explains that portfolio strategies are on hold as investors are beholden to an unpredictable stream of bad news. “The market remains fearful of the ‘known unknowns’. This is from the point of view of markets being unsure just how much more bad news is yet to be revealed. The problem is that the potential impact of a particularly big piece of bad news cannot be discounted in advance.” On a positive note, it explains that an increasing number of investors have been rebalancing their FX overlay positions. “Previously there had been a bias to under-hedge long Asian equity positions to take advantage of the appreciation trends. Now more caution is being taken.”
Daiwa Securities maintains a relatively sanguine outlook for emerging markets, believing the US sub-prime crisis will not become an EM drama. It argues that domestic demand momentum in EM will be sufficiently entrenched to keep growth afloat. But the bank cautions: “growth rates in most EM countries will be moderately lower than those enjoyed in the first half of the year, but in most cases they will remain at or above trend rates. The main exceptions will be Hungary, where growth is likely to remain below 2% year-on-year over the second half in response to the recent macroeconomic policy tightening, and Mexico, which relies on the US for over 90% of its exports, and where growth is likely to struggle to get above 3%.”
Focus may shift to domestic development
Merrill Lynch argues that the crisis may spark off an unprecedented global rebalancing as creditors start to shun borrowers who are closest to the crisis: those in the US. “The perceived increased riskiness of purchasing more US corporate and agency bonds might encourage official institutions toward supporting greater currency appreciation and/or a re-channeling of their savings toward domestic or alternative uses. In layman terms, maybe Kuwait chooses to build a new airport rather than to purchase more US bonds.”
EM carry trades
Daiwa maintains that given the unprecedented popularity of carry trades in recent years, it is unsurprising that EM currencies have been vulnerable to a sudden reversal of risk appetite. In any event, overshooting on the downside is a real possibility. “Indeed, even before the recent market correction, reflecting their strong external positions, the Brazilian real was probably close to its equilibrium level and the Russian rouble was undervalued.” It predicts that, providing Japanese interest rates remains low and market stability is restored, “higher-yielding EM currencies of countries with current sizeable current account deficits (such as the Turkish lira and South African rand) will once more gain support from carry trades.”
Brazil: real economy decoupling from financial market volatility
Merrill Lynch argues that diversification of the country’s export market (only 18% of exports are to the US), its strong external position and diverse sources of domestic growth bode well. But it fears that “a realignment of risk globally, especially if including some measure of carry trade unwinding, could prompt transitory dislocations of Brazilian asset prices and require an adequate policy stance to keep related effects from feeding into the real economy.” Similarly, Moody’s Investor Services positively notes the sovereign’s creditworthiness as economic expansion seems to be self-sustaining, as demonstrated by the fact that: “Brazilian assets made a significant recovery after markets were stabilized by central banks’ interventions. At present, however, markets are still below the pre-turbulence levels.”