Around the world, emerging markets are tumbling. Their currencies are getting slammed and equity markets are selling off.
There is a combination of factors behind the sell-off, including the slowdown in China, unwinding of carry trades, domestic political issues, and monetary policy of the world’s biggest central banks.
But the escape from emerging markets (EM) has been brewing for a while.
Investors have been shifting out of EM since mid-2013, when long-term interest rates began rising in the U.S. as the Federal Reserve primed the marketplace for a long-awaited reduction in monetary stimulus.
Much of the inflows into EM assets in recent years were predicated on a search for yield in the absence of any in developed markets, but as U.S. interest rates have risen in recent months, there has been less and less of a justification to be invested in EM, and those flows have begun to reverse.
Since the beginning of 2014, however, U.S. Treasury yields have reversed course from multi-year highs and have fallen swiftly. Yet EM currencies have continued to tumble, breaking the relationship with Treasury yields established in 2013, as Chart 1 shows.
And while rising Treasury yields have proven to be a challenge for EM, falling yields in the past week or so have become even more toxic, given the environment in which that drop in yields has occurred.
Disappointing manufacturing data out of China last week and grim headlines on developments in the country’s shadow banking system were enough to spark the unwind of levered bets in the hedge fund community that had become too one-sided.
One popular trade in this vein is shorting the yen against higher-yielding EM currencies. When market volatility picked up last week, fast money players started exiting these trades, which is why the sell-off in EM currencies has accelerated.
Meanwhile, many of these EMs are dealing with country-specific issues of their own, even as their currencies come under pressure due to risk aversion.
“The current period of market turmoil may have slower EM growth and the prospect of less accommodative Fed policy at its heart, but it has a lot of regional sub-drivers: China’s shadow banking system, politics in Turkey, strikes in South Africa, more politics in Argentina, to name but a few,” says Kit Juckes, a global strategist at Société Générale.
“There are too many fires burning to expect them to all blow out simultaneously.”
China is perhaps the biggest concern in EM, given its importance as a commodity consumer.
“This week’s weakness in EM has much more to do with China than the Fed,” says Dina Ahmad, a strategist at BNP Paribas.
“A string of trust-product defaults and a much weaker-than-expected HSBC flash PMI reading have fuelled a resurgence of China-collapse fears.”
The country’s systemic importance in emerging markets can’t be understated, and is weighing on sentiment.
“Currently China is the bulwark that stands between south/southeast Asia instability, and dramatic broadening of contagion encompassing the global economy,” says Alan Ruskin, global head of G-10 FX strategy at Deutsche Bank.
“China’s share of global GDP is now four times what is was in 1997. If contagion stretches to China’s credit cycle (not DB’s expectation for 2014), watch out — this would represent a huge escalation in contagion risk.”
The Turkish lira is capturing headlines as, in addition to external pressures, political crisis is sending it plummeting to all-time lows against the U.S. dollar almost every day.
Today, the lira surged after the Central Bank of the Republic of Turkey announced that it would hold an emergency meeting at midnight Tuesday in Ankara.
Last week, the CBRT passed on hiking interest rates at its regularly-scheduled policy meeting, and many believe this decision was influenced by political pressure.
It’s unclear what actions the central bank will take now, but George Magnus, former chief economist and current senior economic adviser to UBS, believes it will announce some form of capital controls.
“It would be pretty unusual to have a meeting and a midnight statement where you were just going to announce a standard change in monetary policy,” Magnus told Bloomberg News this morning.
“The odd time does suggest, to me, something that’s going to be much more market-sensitive in that it will affect the operation of markets, not just the cost of funding.”
South Africa is also at the forefront of the latest turmoil in EM.
Last week, workers at the world’s three largest platinum mines went on strike, marking the latest in an ongoing string of wage battles that have disrupted the South African economy over the last year.
Platinum prices are surging as the rand declines.
“The threat of major industrial action in the South African platinum industry has come to fruition with a strike at the world’s top three producers having started last Thursday,” says Robin Bhar, an analyst at Société Générale.
“If the strike continues for a protracted period (of a month or more), refined PGM output will be hit as the pipeline is drawn down. The weakness of the rand means that South African producers are already receiving the highest rand platinum prices since mid-2008. At present rand weakness gives producers headroom to survive with lower dollar denominated prices, and, as the AMCU are doubtless arguing, in a position to settle at higher wages than would otherwise be possible.”
Treasury yields are rising again today as U.S. markets shrug off last week’s turmoil. This may mark an end to the particular storm that gripped EM last week, but the asset class still has a bevy of longer-term issues to contend with going forward, as various developments across these markets amply illustrate.
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