Emerging markets are now hurting developed economies – rather than the other way round.
The flavour of financial markets for much of the past 12 months has been a strong preference for equities over bonds and for developed equity markets over emerging markets (EMs). The developed equity markets, led by the S&P 500, performed well, even as US long term interest rates rose significantly and consistently between May and September 2013.
Higher interest rates in the US were a response to the first intimations that the US Fed would be reducing the scale of its Quantitative Easing (QE): that is, the rate at which it would be adding to its portfolio of government bonds and mortgage backed Paper and adding to the money base. In December the Fed announced its intention to “taper” its injections of cash from US$85bn a month to US$75bn. This action was well received by developed equity markets. It was interpreted as confirming the good news about the state of the US economy, thus helping the earnings outlook for US corporations and their market value.
By contrast EM equities did not react at all well to the news about tapering and higher US interest rates. At best EM equities tended to move sideways or lower in 2013 as long term interest rates on EM bonds followed US rates higher. Hence developed market equities significantly outperformed EM equities.
The outlook for EM economies was widely regarded as deteriorating in 2013, even as that of the US was improving, making higher interest rates for EM borrowers distinctly unwelcome. Not only did EM equity and bond markets weaken, but EM currencies came under pressure as funds rotated away from emerging to developed markets. The performance of the JSE and the rand proved no exception to the other EM markets and currencies.
Indeed the rand has been among the weaker of the EM currencies. Commodity based currencies, including the Australian and Canadian dollars, also weakened significantly in response to uncertainty and unease about the prospects for the Chinese economy, the leading EM economy that has such an important influence on demand for commodities like iron ore, copper and coal.
The comfort zone in developed market equities however became significantly smaller on Friday 24 January. The risks in emerging economies on the day infected developed markets. EM contagion became the order of the day. Long term interest rates fell sharply as investors sought safety in US bonds and US equities fell away as risk appetite waned. EM currencies came under particular pressure and while long term interest rates in the US fell those in EM currencies, including the rand rose. Risk spreads across the board, including US corporate spreads, rose rather than fell with lower US rates.
In this way EMs were subject to a risk off threat just as they had previously been subject to a risk on threat. All news has appeared as bad news for EMs. Both higher as well as lower US long term rates have proved unhelpful to EM equities, bonds and currencies.
Investors in EM markets, including those equity investors whose wealth is measured in rands, should wish for higher rather than lower US long term interest rates, that is for US economic strength rather than weakness. In the longer run what is good for US business will be good for EMs and SA business.
In the shorter run the challenge for EM economies, especially the SA economy, is to turn a much more competitive currency into export and import replacement led growth. Constructive labour relations and constructive government relations with SA business, in the form of encouraging tax policies and infrastructure roll out, are essential to this purpose. It will also be helpful if the Reserve Bank continues to leave interest rates on hold while leaving the exchange rate to help the economy adjust to higher costs of capital. The mantra for monetary policy should be to float with the tides rather than attempt, Canute like, to reverse them.