When considering the decline in emerging markets, Sir Michael Hintze, founder of London-based hedge fund CQS, says investors shouldn’t have been surprised.
Hintze: “Quantitative easing is stimulating downtown Mumbai rather than downtown Detroit”
Hintze clearly stated in 2011 that quantitative easing is “stimulating downtown Mumbai rather than downtown Detroit,” pointing to the often-cited issue. “It is surprising to me that as Taper takes hold, effectively a tightening of money supply growth, the reverse (in emerging markets) is not obvious,” he said in an investor letter reviewed by ValueWalk.
“It is worthwhile remembering that when QE started there were massive capital inflows into Brazil, India and other developing countries,” he wrote. “Conversely, as Taper continues, we believe the magnitude and perhaps velocity of these flows will change.”
Hintze: Currency wars ensuing
Noting the likely impact of the taper on emerging markets, Hintze says “The policy response in many EM countries has been to raise rates at a time when Taper is resulting in a withdrawal of liquidity, consequently exacerbating a contraction in money supply.”
Bunt Ghosh, Senior Advisor at CQS, said that due to the Fed taper, capital outflows haven’t been the “proximate cause for the crisis, but it could be argued that the aggregate annual data may hide the detail apparent from the last few months of flows.”
Ghosh notes that abnormal capital flows could be expected to led to a countercyclical policy in emerging market countries. Instead, they have created “currency wars” because of concerns that an appreciating currency would jeopardize their growth prospects. As a result, Ghosh notes that “…monetary conditions post the ‘tech’ crisis of 2001 have been systemically too loose in EM countries and the problem has only become worse.”
Will these market issues of the previous months lead to a full blown emerging market crisis? “Not immediately,” Ghosh said, “but the prospect of further significant market volatility and downside in the next twelve months cannot be ruled out.”
Four drivers of emerging market crisis
Ghosh points out a potential emerging market crisis has four drivers:
1. Some countries still have a considerable amount of leverage
2. Many Emerging Markets will find themselves squeezed by higher inflation because of food prices and wage pressures and slower growth as leverage is unwound
3. Continued asset allocation in favour of DM will result in further outflows of capital
4. Many EM countries face elections from now through to the end of 2015 which suggests that the likelihood of any of the major structural issues being addressed is low
“Valuation alone is not the major reason to be cautious,” Ghosh notes. The significant outflow of capital has forced a substantial monetary tightening in most of these economies and many of the central banks have also raised rates. In an environment of relatively weak growth, with the Fed beginning its tightening cycle and European economies at risk from deflation, there is a real risk that within the next 12 months we could have far too much tightening globally. All countries cannot run a current account surplus. To allow for global growth (see Figure 8), some countries need to run a deficit and the largest of these has historically been the United States. This appears now to be changing. The latest estimate has seen the current account shrink to a deficit of only -2.4% of GDP for 2014 and consensus forecasts have it shrinking further (to -2.1% of GDP by 2015) (see Figure 9).
“For the United States to resume its leadership role in global growth, the US dollar must start appreciating on a trade weighted basis,” Ghosh concluded.