Jan 20: Green shoots vs. yellow weeds
The apparent decoupling between asset markets – EM equities, in particular - and continued macro stress this week is a source of optimism for some and fear for others. Take your pick.
Is the proverbial emerging markets glass half-full? Or is it teetering on the edge of the table, about to smash into a million pieces?
Risk assets rallied to multi-month highs this week, with emerging markets leading the way. The MSCI Emerging Market Index was up more than 4% on the week as of midday London time, against the backdrop of increased confidence that the European Central Bank will prevent an imminent banking crisis in the eurozone, buying policymakers more time, as well as encouraging economic data from the US, above-consensus GDP growth in China, and signs that Indian policymakers may finally be winning the battle with inflation.
Greek debt talks also appear to be inching closer to some form of resolution, while the IMF announced its intention to boost its funding by up to $600 billion, which, if successful, would greatly enhance its ability to help mitigate against potential global (read: European) shocks.
Yet, for all the positives, the signs of underlying macro stress are unmistakable. The World Bank issued a stark warning on Wednesday, suggesting that a Lehman Brothers-type event in Europe or the US could shave 4.2% off GDP growth in developing nations by 2013, plunging many emerging economies into outright recession. European officials and banking regulators warned that Central and Eastern Europe faces the very real threat of a credit crunch that could dwarf the downturn in 2008 unless safeguards a Vienna Initiative 2.0 are introduced as a matter of urgency. While the ECB has bought eurozone leaders some breathing space, there are few signs that they are taking advantage of this to address the underlying structural weaknesses within the single-currency bloc. Greek debt talks - even if an agreement of sorts is fleshed out - appear simply to be postponing the inevitable.
The threat to the EM outlook is not just from developed markets. Despite the better-than-expected headline numbers from China, falling house prices and a slowdown in construction and investment growth have heightened fears that the countrys vital property sector has entered into a tailspin. A prolonged property downturn would drag down GDP growth rates and exacerbate concerns about burgeoning local government debt levels in the worlds second largest economy. Hungary teetered on the brink of financial implosion this week, although Prime Minister Victor Orban made some concessions this Friday.
Against this backdrop, the moves by emerging market policymakers across a number of regions to ease policy can be interpreted in a number of different ways. Brazil, Indonesia, the Philippines and Chile all moved to cut interest rates or overnight repo rates this week, in moves that have been characterised both as a sign of proactive policymaking, or as an indication that developing nations are increasingly wary of the brewing storm.
Investors face a similar quandary. This weeks rally has prompted a number of sell-side EM evangelists to suggest that now is the time to re-engage with EM assets, equities in particular, given attractive valuations and seemingly positive fundamentals. But similar messages accompanied a number of risk asset mini-rallies last year, only for optimism to be dragged down once again by the severity of the macro and financial sector risks. In sum, the jury is out on whether the first few weeks of 2011 will prove to be another false-dawn or whether the tide finally turned back in EMs favour.