|By Steen Jakobsen|The negative start to this year came as a surprise to most investors as we came into the new year with the usual euphoria and expectations of a stock market ending 2014 up 10-15% and a Europe and US in continued recovery but January soon became all about a potential EM crisis which ended up hurting even developed markets return in this year first month. The question now is how real is the threat of an EM crisis?
I think it’s for real – the world is in a global rebalancing act where the by product is lower growth globally, deflation in the developed marked and much weaker EM currencies as the FX weapon is seen as the only real option for economies desperate to maintain export growth. This creates a capital flow away from EM and equities as the investor rediscover the safe haven of bonds.
There is a big cyclical and structural slow-down in the world right now: Asia, which almost on its own carried the globally economy through the crisis from 2008 to 2012, is now slowing down proactively. China, 36% of world growth in 2012, seeks to reduce its shadow economy, fight corruption and recapitalize the banks to secure a soft landing as the credit expansion slows down. Rest of the Asia, 24% of world’s growth, has current account deficits to fight. During 2013 many of these countries, specifically, the Fragile Five (South Africa, India, Indonesia, Turkey and Brazil) saw their currencies fall dramatically as their hitherto stabile financing needs moved into big deficits making them more dependent on foreign investors and global monetary policy. The BRIC countries as a whole moved from surplus of 5% to GDP pre-crisis to barely breaking even, and inside BRIC, China is the only exception with surplus.
What is important to know about EM investment is this: When you buy an EM bond portfolio, like ELMI, 100% of your return comes from stronger FX. Similar when you buy EM equity 70% of your return is again from FX revaluations. Now, these EM countries are presently all seeking lower/weaker currencies which means for an investor the incentive to buy and finance EM have disappeared. Why buy an EM portfolio when the 100% in bonds and 70% in equity has declared “not happening” by government and central banks concerned about their current account and growth? In other words, the short term policy of devaluing your currencies to create increased competition has destroyed the very reason we as investors buy EM. A viscous cycle has started.
This is exactly why this EM crisis is not going away. If, the goal is to get inflow to EM, then the government needs to stop weakening their currencies and seek reform and stable currencies. Instead we get a “race to the bottom” between these export machines. The overall problem is that we can’t all run export surplus at the same time, someone needs to import. The EM countries move from agricultural economies to export machines mainly having an edge from low wages and capacity, as these economies grows they get a big middle class which wants better more expensive products often imported. This moves the trade balance into deficit, and after some years the current account follow through we an ever increasing need for accessing foreign investors to fill the gap between the increased consumption in EM and the export.
The problem, of course, is being that what really would help these economies are reform and a program to reduce export dependence. This will be long coming, not less, because many of these countries have elections in 2014. An election year means no new reforms, and a policy designed to maximize the voters’ expectations which often mean subsidized energy and food in the EM countries, not something which improves imbalances – on the contrary.
Finally, we need to embrace this EM crisis; it is the final phase of this crisis/rebalancing. It shows on one hand that EM countries are less competitive and need to rebalance their economies, but on the other hand it also means someone “else” is benefitting (current account data is zero globally). This someone are the US and Europe. The US primarily through very low energy costs compared to the rest of the world (Shale gas have made natural gas ½ the price of European natural gas) and Europe through low wage demand and soon deflation depressing prices. The world is simply more balanced than before the crisis, so when the real recovery comes it will be from a point of exit which is balance, less leveraged and more transparent and that is excellent news for next decade after this crisis finally ends. This final phase of this crisis comes after the US housing and bank crisis (2008/2010), then the European debt crisis (2010/2012).
Asia carried the world on its shoulder so far in this crisis; as the world slowed down, Asia continued to keep very high investment ratios. Investment, which had big European and US content, meaning Europe and US had slowing domestic economies, but foreign demand through export orders to Asia. Now these same investment levels needs to adjust downward to the lower growth of Asia, the price is we all slow down and face lower inflation. The EM countries need time to rebalance and to get to a point where the mandate for real changes is established – The early sign of FX manipulation means we are closer, but not yet there.
Get to know your EM and its currencies where we end in 2014 in terms of return on our portfolios could very well be more dependent on where USD/TRY, USD/IDR, USD/INR and USD/MXN than on what Yellen and FOMC does. To me that’s a good thing.
Steen Jakobsen is CIO & Chief Economist at Saxo Bank
