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LGT Beacon: Cold Turkey

February 5, 2014

Global financial markets have been very nervous since mid of January. Not only global equity markets suffered losses, but also the broad range of emerging markets assets. Although we currently do not see an outright "emerging markets crisis" – like e.g. the Asian crisis of 1997/1998 – investors should, for the time being, remain cautious with regards to emerging market assets.

2013 was a bad year for emerging markets (EM) asset classes. While EM equities lagged their elder siblings from developed countries since the start of last year, other EM assets, such as currencies and bonds, also began to suffer with the US-Fed announcement that it would start to slowly, but steadily, take its foot off the monetary accelerator. The pressure intensified beginning of this year after a string of negative news from different developing countries accumulated (high political uncertainty in Ukraine, corruption scandal in Turkey, depreciation of the Argentine peso and disappointing macro data from China). Especially hard hit were the countries which have a current account deficit. This is not only the usual suspects Turkey, South Africa, Brazil and India, but also commodity exporting countries such as Chile, Colombia or Indonesia who are suffering under weak commodity prices.

What is the issue?

Since the global financial crisis, the ultra-expansionary monetary policy of the Western central banks has been the major influencing factor behind the large capital inflows in emerging markets. Some countries have literally been overrun by the monetary tsunami. Such money, however, goes as quickly as it comes. It was the prospect of a monetary tightening by the US-Fed (“tapering”) that changed the direction of these capital flows. During the last few weeks, however, there was also another reason why international investors have withdrawn capital from emerging markets at record speed. It was the fear of a broad emerging market crisis that led to a sagging market sentiment towards EM assets. Among others, the fear was caused by the uncertainty with regards to the anticipated default of a Chinese Wealth Management Product (“WMP”) and what it would mean for the Chinese financial system.

However, not only the currencies and asset prices are suffering from negative investor sentiment, but also the real economy of some countries. First, weak currencies increase import prices (especially for energy) which boosts inflation pressure. In order to strengthen their credibility and support their currencies, some central bankers had to react and increase policy interest rates – above all the Turkish central bank which ended the monetary experiment it had started in 2010 and both simplified and tightened its monetary policy by a big margin. Second, capital outflows and higher local interest rates mean financing costs are increasing and hurting the domestic economy.

Not a global emerging market crisis

Even though correlations among different emerging market assets have been rising markedly during the last few weeks, we currently do not see a global “emerging market crisis” like the Asian crisis of 1997/1998, as other market observers are proclaiming. Sure, the global money glut is slowly being shrunk. But most emerging countries are less vulnerable than they were before previous crises hit. They now have flexible exchange rates, higher foreign currency reserves, lower public debt ratios and a higher part of their debt is denominated in local currency. This means that, on aggregate, both their monetary and fiscal flexibility to support their currencies and their economies is higher than in the past. Fundamental data therefore do not warrant large-scale capital flight out of emerging markets. Nonetheless, the pressure on EM currencies could intensify going forward: If the fear of an outright EM crisis were to increase and were to lead to further heavy capital withdrawals by international investors, it could become self-fulfilling.

Investors should remain cautious for the time being

From a valuation point of view, emerging market equities are cheap – both absolute to their own history and especially relative to their developed counterparts – and most EM currencies have fallen to fair or even well below fair value. But the discounts are not big enough that they alone would justify buying EM assets. However, broad price corrections can be used to selectively buy exposure in the countries with solid fundamentals and better perspectives.