The uncertainty over the US “fiscal cliff” – the automatic tightening of fiscal policy that would take place unless there is political consensus to continue the easy stance – is likely to continue after the November 6 presidential election, strategists at HSBC said in a note looking at the various scenarios for after the vote.
“We still believe investors should consider adding to EM equities as domestic demand remains resilient, yet the rally is likely to regain traction once there is more clarity on the final impact of the fiscal cliff on US GDP growth,” they wrote.
The ‘risk-on’ mode, which started back in July when European Central Bank (ECB) president Mario Draghi pledged to do “whatever it takes” to save the euro and was fuelled by the third round of quantitative easing (QE3) from the US Federal Reserve, has turned to ‘risk-off’ before the election.
One reason is because a second “cliff,” a monetary one consisting of the potential replacement of dovish Fed chairman Ben Bernanke with a more hawkish governor if Republican Mitt Romney wins, has emerged during the election campaign, the HSBC strategists said.
“While this remains a low probability event, it would have important implications for appetite for EM risk,” they added.
While the fiscal cliff would send the US economy into recession, with consequences on emerging markets’ exports and growth, the monetary cliff, if it occurred, could “provide a blow to the long fixed-income positions that have been accumulated after several years of easy money.” According to the HSBC strategists, local yield curves are on average around 50 basis points flatter than what they should be judging solely by their domestic economic cycle, due to a combination of the low level of US interest rates and the slope of the US Treasuries.
WINNERS AND LOSERS
Hard currency debt in emerging markets “appears to be the least sensitive of all EM asset classes in the context of the potential scenarios brought by the ‘cliffs,’” they said, although it would be hurt by a double-whammy of a fiscal cliff-induced recession and higher interest rates in the US. However, HSBC analysts consider this scenario “highly unlikely.”
Local currency debt is usually more sensitive than hard-currency debt to domestic macroeconomic conditions and the best scenario for local rates would be a combination of the weak economic performance that is already expected if a full fiscal cliff happens and a continuation of the low-for-longer US interest rates policy, they said.
Emerging markets foreign exchange “remains very much a risk on – risk off asset class and thus would tend to perform better in scenarios of low uncertainty,” the HSBC strategists wrote.
“The worse the outlook for global growth, the higher the aversion for risk will be and the more likely EM FX will underperform.”
EM FX will perform better in a recovering economy-low US interest rates scenario but local central banks, particularly in Brazil, Colombia, Chile and the Czech Republic as well as in some Asian countries like the Philippines have made it clear that they do not like their currencies to appreciate too much.
Stocks in emerging markets “are very sensitive to the growth prospects of local economies,” the HSBC analysts said.
“Yet stocks could be provided a lifeline from ample liquidity conditions, as we see valuations being more subject to fluctuations in the global risk premium than actual economic activity itself” but are currently weighed down by the “recent pickup in election uncertainty,” they added.