Financial markets this week were thrown into tailspin amid a bout of extreme turbulence, which leading bankers and investors believe could herald the start of a widespread rebalancing and a new-found aversion to risk.
Concerns over rising interest rates, inflation and global growth forced a widening of emerging market bond spreads as all major currencies suffered price corrections and commodity markets slumped, triggering pandemonium across markets. Markets in Brazil, Indonesia and Poland all suffered following a collapse in emerging market currencies.
Bill Rhodes, senior vice-chairman of Citigroup, told Emerging Markets in an interview: “an adjustment in the markets will take place” now that borrowing costs are rising, after a period of excess liquidity and a prolonged stretch of indiscriminate behaviour by investors and lenders.
“The question is: when and how much of a correction will there be?” Rhodes said, adding that the profusion of complex trading instruments such as credit derivatives adds new and unknown risk to the situation.
After 16 months of raising rates, Federal Reserve chairman Ben Bernanke is unsure which way borrowing costs are headed next.
Eastern Europe, which has witnessed a massive narrowing of spreads, could be the major victim of the shake-out because it has a bigger external financing requirement - $156 billion for 2006, according to Fitch - than Asia or Latin America.
“Rising interest rates will inevitably have a major effect on investments in eastern Europe, as in the low return environment of the last few years, a lot of funds were trying to beef up their returns by investing in higher risk areas,” Hans-Joerg Rudloff, chairman of Barclays Capital, told Emerging Markets.
The story is not about fundamentals: the IIF will predict in a report released later today that the eastern European region will grow 5% in 2006, comfortably outpacing the eurozone again. And both investors and analysts point to the fact that structural improvements made, particularly by countries planning to join the European Union, mean this slump may be shallower than previous downturns.
“After a long period where volatility has fallen and stayed very low we’ve turned a corner, gone through a cusp and I think volatility will go up,” warned Arnab Das, Dresdner Kleinwort Wasserstein’s head of emerging markets research. That said, “I don’t think it will be as bad as it has been in the past.”
The currency moves, which have seen the Turkish lira slide about 20% in two weeks, are likely to continue as investors demand more for taking risk.
“There are a number of factors that could lead to the conclusion that the riskier asset classes could lead to a prolonged conclusion,” said Michael Discher-Remmlinger, senior portfolio manager at PIMCO. Corporate bonds and countries with poorly financed current account deficits including Hungary and Turkey are likely to suffer most, he told Emerging Markets.
Nevertheless the message from experienced hands is: don’t panic. “If you look at the valuations in the market they’re not excessive, I don’t think a fully-fledged crash is on the way,” Mark Mobius who runs emerging markets investments at Franklin Templeton Investments, told Emerging Markets. He’s been buying heavily in China and Korea and also picking up shares in Russia, South Africa and Brazil in the past week.