The month of September is a key one for the future of global growth, as talk about the Federal Reserve's tapering off its quantitative easing policy has shown how important to the world economy have emerging markets become.
The BRICs (Brazil, Russia, India and China) now account for close to 20% of global gross domestic product and if the so-called Next 11 are added (a group of countries including Indonesia and Turkey for instance) the number rises to 28%, larger than the US or even the European Union.
So the growth prospects in these countries are likely to have more of an impact than ever before, something that the Managing Director of the International Monetary Fund, Christine Lagarde, highlighted in her speech at Jackson Hole.
Emerging markets are continuing to feel the heat. Outflows in both bond and equity emerging market funds picked up again last week. Local currency funds were particularly targeted. Currencies continued to weaken, though central banks are now stepping up efforts to contain the hemorrhage.
Brazil hiked its target rate again by 50 basis points last week to 9%. Indonesia has done so as well, raising rates by 50 basis points to 7%. This, combined with announcements of swap agreements in India and re-iteration of reserve levels seems to have stopped the runaway depreciation against the dollar for now.
On the whole, emerging markets are better equipped to deal with a pullback in investor interest. External debt levels are typically lower, foreign reserves higher, central banks have been loath to use up reserves to defend recent currency slides and banking systems have progressed since the last emerging market-driven crisis.
However, with the normalization of interest rates in the US, emerging economies are going to be forced to review deficit levels, debt levels (particularly in China), consider structural reforms in a tightening credit environment: an exercise Europeans have painfully been subjected to since the onset of the sovereign crisis with the known consequences on short term growth.
EUROPE STILL VULNERABLE
In this context, will the fragile growth in developed markets be sufficient to provide a growth relay to the global economy or will the ripple effects of tapering in emerging markets prove too much to handle?
Data out of the US and Europe continues to be supportive. Just last week, US second-quarter GDP growth was revised up to 2.5%. High level consumer numbers continued to show a positive streak.
In Europe, flash PMIs are still progressing. Confidence indicators are building up momentum. Money supply is expanding. European central banks are still guiding to a supportive monetary environment, sounding more dovish than their US counterparts.
While a convalescent banking system, austerity and structural reforms are still on the agenda for Europe, progress has been made and the path has been paved to see some growth materialize. The risk is that this progress is nipped in the bud for internal or external reasons.
Europe remains vulnerable to a recessionary environment as it continues to deleverage its banking and public sectors. The risk remains higher to the downside for now as balance sheets are still in repair mode. Confirmation of growth, particularly in the periphery, is the key going forward to the continued contraction in the European risk premium.
This balance of risks is likely to make for an interesting autumn. Spreads [the credit spread to European and US swap rates] have come a long way over the summer. In Europe, credit spreads have recovered some 80% of the sell off since the 22nd May and in the US just over 60%.
European credit was helped by a very light issuance calendar. New issuance activity only really picked up last week and has tended to re-price secondary curves particularly in the high quality space. Despite new issue premia of 5-10bps, new issues have only modestly performed if at all.
As activity picks up this week, we will have more colour on investors’ true appetite for risk. Growth would be supported by an increased risk appetite. Investment remains slow in developed markets, businesses need to invest more in growth initiatives. This is only likely to occur as risks fade in investors’ minds.
- Henrietta Pacquement is Lead Portfolio Manager at ECM Asset Management