Catching a falling knife

After a very long absence and much to the neglect to Econometer.org I am pleased to write a new post and apologise to those that subscribed to my blog, for the very long delay since my last post.   There is so much to say about the market turmoil at present, it is almost hard not to write something.

For those of you with eyes only on the continued strength in US stocks, which have hit record high after record high in recent weeks, it may be shocking news to your ears that the rest of the world, especially the emerging markets (EM) world, is in decidedly worse shape.

Compounding the impact of Federal Reserve rate hikes and strengthening US dollar, EM assets took another blow as President Trump’s long threatened tariffs on China began to be implemented.  Investors in countries with major external vulnerabilities in the form of large USD debts and current account deficits took fright and panic ensued.

Argentina and Turkey have been at the forefront of pressure due the factors above and also to policy inaction though Argentina has at least bit the bullet. Even in Asia, it is no coincidence that markets in current account deficit countries in the region, namely India, Indonesia, underperformed especially FX.  Even China’s currency, the renminbi, went through a rapid period of weakness, before showing some relative stability over recent weeks though I suspect the weakness was largely engineered.

What next? The plethora of factors impacting market sentiment will not just go away.  The Fed is set to keep on hiking, with several more rate increases likely over the next year or so.  Meanwhile the ECB is on track to ending its quantitative easing program by year end; the ECB meeting this Thursday will likely spell out more detail on its plans.  The other major central bank that has not yet revealed plans to step back from its easing policy is the Bank of Japan, but even the BoJ has been reducing its bond buying over past months.

The trade war is also set to escalate further.  Following the $50bn of tariffs already imposed on China $200 billion more could go into effect “very soon” according to Mr Trump. Worryingly he also added that tariffs on a further $267bn of Chinese goods could are “ready to go on short notice”, effectively encompassing all of China’s imports to the US.  China has so far responded in kind. Meanwhile though a deal has been agreed between the US and Mexico, a deal encompassing Canada in the form a new NAFTA remains elusive.

Idiosyncratic issues in Argentina and Turkey remain a threat to other emerging markets, not because of economic or banking sector risks, but due increased contagion as investors shaken from losses in a particular country, pull capital out of other EM assets.  The weakness in many emerging market currencies, local currency bonds and equities, has however, exposed value.  Whether investors want to catch a falling knife, only to lose their fingers is another question. which I will explore in my next post.

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Who’s going to follow in Brazil’s footsteps?

Last week saw a sell off in some emerging market currencies and whilst this may simply have been profit taking attributable to some large hedge funds it did coincide with the imposition of a tax on portfolio inflows in Brazil.  The tax dented sentiment as it quickly fuelled speculation that it would be followed elsewhere, especially in countries that had seen rapid FX appreciation.  

The BRL is one of the best performing currencies this year against the USD whilst the stock market has surged on strong capital inflows.  The huge increase in USD liquidity globally and substantial improvement in risk appetite has fuelled strong capital inflows into Brazil especially as the country has proven to be one of the most resilient during the crisis.

Although on the margin the tax will have a negative impact on speculative flows into Brazil it is unlikely to have a lasting impact.  Previous such measures have done little to prevent further appreciation.  The BRL is clearly overvalued by around 25-30 at present, but the tax in itself will not be sufficient to result in a move back to “fair value”. 

At best it may act a temporary break on currency appreciation and could limit the magnitude of further gains in the real but this could be at the cost of distorting resource allocation and market functioning.   The longer term solution is to enhance productivity but this will not help in the interim. The tax may make investors a little more reluctant to pile into Brazilian assets, which is what the authorities will desire but already the BRL is back on its appreciation path suggesting a short lived reaction. 

Other countries that could follow include South Africa, Turkey or South Korea but South Africa has already denied that it has any plans to move in this direction.  In South Korea’s case the central bank has chosen to intervene in currency markets to prevent the further strengthening in the won but that also has implications for sterilizing such flows limiting the extent that intervention can be carried out.    

The bottom line is that the broad based improvement in risk appetite is proving to be a strong driver of capital flows into emerging markets and the reality is that many emerging economies such as Brazil and many in Asia have been much more resilient than feared. 

Although there is clearly a limit on the extent that these countries want to allow their currencies to strengthen versus USD the upward pressure will continue, leading to more FX intervention and potential imposition of taxes or restrictions such as implemented in Brazil.   Despite this the outlook for most emerging currencies remains positive and the authorities will face an uphill struggle. 

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