Markets Crying For Argentina

By Dr Jerry Webman, PhD, CFA, chief economist, OppenheimerFunds

Anytime markets drop and you start seeing news stories talking about emerging market (EM) currency crises and contagion, it’s hard not to think back to episodes like the 1994 Tequila Crisis or the 1997 Asian financial contagion.

In light of last week’s EM-centered volatility, however, let’s be clear: This is not 1994 or 1997. Certainly, some of the more problematic emerging markets, including Argentina, Ukraine, Venezuela and Egypt, and to a slightly lesser extent Turkey, have suffered under various combinations of fiscal and monetary mismanagement and political turmoil.

But while elevated risks are present in some other emerging economies, I do not expect a wave of crisis to sweep across the emerging world, landing ultimately on developed-market shores.

What’s the problem?

Remember decoupling? In the aftermath of the financial crisis, capital flows followed the attractive combination of better growth prospects and a significant yield pick-up in EM sovereign debt and poured into emerging economies’ bond markets.

The surge in capital flows allowed some such countries to finance larger debt levels at ever-lower interest rates. This symbiosis worked until mid-2013 when improvements in US, European, and even Japanese growth prospects and the threat/promise of reduced Federal Reserve asset purchases triggered a full percent rise in US 10-year Treasury rates.

EM yields generally moved in sync with US rates but no longer provided investors with enough of a yield spread over the US to maintain the one-way flow of capital. As flows reversed, the tide went out, and the market had full view of those countries that had binged on cheap credit and found themselves with worsening current account deficits, fiscal deterioration, and inflation concerns.

Is the market painting all EM countries with one brush?

Unlike previous emerging debt sell offs, however, the market is already discriminating between the above-mentioned financially and politically troubled EM countries and the more fundamentally sound countries like Mexico, Korea, Chile, Czech Republic and others.

Unlike the EM debt crises of the 1980s and 1990s when sharp deteriorations in EM currency values rendered them unable to pay back dollar-denominated debt, the ability of these countries to issue debt in their own local currencies should, in my opinion, prevent the current market decline from becoming a pandemic.

Countries that have combined this key differentiator with prudent fiscal policies, independent central banks, current account surpluses and foreign exchange reserves have become sturdier credits than in the past and are likely to avoid the contagion from spreading to their doorsteps.

Might EM currencies potentially fall under further pressure?

In short, the answer is yes particularly for those countries with current account problems. If these currencies were significantly overvalued before the recent market decline, we should expect to see gradual improvements in export growth and therefore current accounts. In some cases, currencies (and wages) may need to fall further to restore global competitiveness, particularly given the relatively weak global trade picture.

Real yields will also likely have to rise above those in the developed world in order to attract capital. Central banks in countries such as Brazil and Indonesia have already raised interest rates to combat inflation and others will likely have to follow suit.

Although we believe that over time the currencies of the more fundamentally sound EM countries will stabilise, we recognise that should investment outflows continue in the near term, the “safer” currencies may pay a price for the liquidity they provide. The dollar and other safe-haven currencies like the yen will be the likely beneficiaries.

Decoupling 2.0

As for the rest of the world, last week’s global decline in risk asset prices reflects several intertwined concerns, including an arguably overextended US stock market, signs of weakening growth in China (a preliminary January reading of the Markit/HSBC Purchasing Managers Index fell to 49.6 from 50.5 in December, below the dividing line between expansion and contraction), and the recognition of structural issues in several emerging economies. As these concerns have built, US markets have also fallen under pressure. 

As for developed economies, we’re seeing the flip side of last decade’s “decoupling,” with developed-market economies strengthening relative to those of several emerging markets. That cyclical divergence will likely persist. The paradigm used to be that when the US sneezed, emerging markets caught a cold. Now, when emerging markets sneeze, the US, itself, is likely to get a sniffle.

The current downturn in emerging markets appears to be a cyclical event, and while the recent volatility may give all risk assets a jolt, everything we know about developed-world equity markets tells us that a pullback may be a buying opportunity, not a disaster.

In fact, many market observers, me included, have noted that US stocks have not seen a 20% correction since 2011. We’ve had a great, nearly unbroken bullish run, and when that happens, sentiment tends to get ahead of itself. While valuations are not particularly excessive—we’re not seeing irrational exuberance—a limited pullback at some point is to be expected.

Not being a trader, I won’t hazard a guess as to when exactly that may come, but after it happens, I do expect equities to continue their advance, outperforming bonds.

Fourth quarter earnings looking good so far

Two weeks into fourth quarter 2013 earnings season, 68% of the 122 S&P 500 companies that have so far reported have beaten sales estimates, and 73% have beaten earnings expectations. On average last quarter, companies have beaten earnings estimates by about 6%, with financials, tech and materials posting the biggest surprises so far.

Shares of companies in the US that have failed to beat earnings expectations have declined by 5% on average while those that have exceeded analysts’ estimates have climbed by 2% on average. A key question for some time has been whether companies will be able to drive earnings growth with increased sales, as opposed to simply cutting costs.

In this regard, healthcare, financials and tech have fared best so far in the current earnings season. Looking ahead, investors will be paying close attention to the effect of potentially higher interest rates.

Over the past five episodes of rising rates, the technology, consumer discretionary and materials sectors have had the highest average annualised returns, with staples, utilities and telecoms faring worst. In other words, cyclicals have outperformed defensive sectors, though stocks overall have performed quite well in the last four rising-rate periods.

 

Related articles

Grim Times For Emerging Markets

Standard Life Launches New EM Debt Fund