Emerging markets look less vulnerable to a financial crisis they were in the past

Photo by Kevin Frayer/Getty Images

If recent economic data and confidence among those in financial markets is anything to go by, it looks like the European Central Bank (ECB) may be about to announce a tapering of its asset purchase program, potentially before the end of this year.

Bond purchases will slowly decline, beginning a normalisation of monetary policy from the emergency levels at which it currently sits.

Like the US Federal Reserve before it, the question many are now asking themselves is what will happen once tapering begins, especially in emerging markets, highly exposed to the ebbs and flows of global capital flows.

Will it be a repeat of the “Taper Tantrum” that engulfed financial markets back in 2013 when the Fed announced it would start to reduce its quantiative easing program, or will it be smooth sailing, maintaining the calm in financial markets that has been seen for much of this year?

No one knows the answer for sure, but to the global equity strategy team at Bank of America-Merrill Lynch (BAML), emerging markets appear to be much better positioned now than what they were in the past based on its financial vulnerability modelling.

Ajay Singh, Kapur Ritesh and Samadhiya Aritra Baksi, strategists at BAML, explain:

Of the 17 Asian/emerging markets (EM) that we run these models for, only one — the Philippines — shows high financial vulnerability. During the “Taper Tantrum” episode in 2013, 10 out of 17 suffered from high financial vulnerability. It is of little surprise to us that Asian/EM credit default swaps (CDS) and bond spreads are low. This is despite the strong USD over the past two years, falling commodity prices, and worries about the Chinese credit cycle. This simply reflects the solid and improved macro fundamental in these markets.

This chart from BAML shows the improvement when it comes to financial vulnerability in emerging markets compared to 2013.

Source: BAML

“There is a strong correlation between the breadth of countries with high financial vulnerability, and the actual outcomes of financial crises,” says Singh, Ritesh and Baksi.

“However, today’s low levels of financial vulnerability for most markets are well below levels that triggered the last banking or currency crises, a drop of more than 20%).

“When financial vulnerability is high, in 15 of 17 equity markets, returns in USD terms have been far worse than when financial vulnerability is low.”

The trio describe the current fundamentals in these nations as “exceptionally good”, suggesting longer-term stock investors should take note of this.

However, they remain aware that there’s still plenty of risks — both known and unknown — meaning that they’ll be keeping a close eye on the financial vulnerability metrics regularly.

“Of course, risks abound,” they say. “A global recession, an unruly deleveraging in China, a policy mistake by developed market central bankers, or geopolitical risks could change the calculus.”

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