Emerging equity markets rose late last year in a relief rally as US bond yields declined and expectations of the first increase in the Fed Funds Rate were deferred to the new year.
Nevertheless, because some of these markets are hostage to foreign flows and sentiment, long-term investors are likely to allocate asset from markets with weaker fundamentals to those with more robust foundations. The US Federal Reserve’s surprise decision to postpone unwinding of its ultra-easy money policy may provide a temporary boost, but it will not change these underlying trends.
From an equity investor’s standpoint, financial conditions in Asia tightened considerably during the second quarter of 2013 as foreign injections into the monetary base slowed or – in the case of Indonesia – declined. Rather than offsetting this tightness in foreign liquidity, policy-makers in India, Indonesia and Turkey compounded the deterioration in the third quarter by tightening domestic liquidity conditions.
These policies have the effect of sacrificing growth to support exchange rates. While the policies are likely to be belatedly reversed, potentially triggering a turnaround in the outlook for markets, this may not happen soon enough to prevent a slowdown in economic and earnings growth.
Foreign investors are overweight in Indian and Turkish equities and neutral on Indonesia. Conversely, they are neutral on Indonesian and Turkish bonds. This implies that significant foreign capital may still flow out from India and Turkey, benefiting economically stronger markets including the Philippines, Malaysia and Taiwan.
Policy-makers’ decisions to tighten domestic liquidity via measures such as raising the cost of borrowing from the central bank (in India and Turkey) and increasing base rates (in Indonesia) are rooted in fears over inflation and the funding of current-account deficits.
Standard Chartered’s 2014 current-account-deficit forecast for Turkey is 8 per cent, for India 4 per cent and for Indonesia 2 per cent of gross domestic product, and we forecast 7-per-cent inflation in each of those countries. In all three, raising the cost of funds is aimed at attracting foreign capital to fund the current-account deficit and shore up the currency to limit imported inflation.
US$36 billion of foreign capital flowed out of emerging-market (EM) equity markets from April to mid-September. This has weighed on domestic money and liquidity creation. By-products of this slowdown include depreciation pressure on exchange rates and anxiety over the funding of current-account deficits.
Policy-makers have sought to stabilise exchange rates and attract foreign flows via higher interest rates and administrative measures. These policies have also weighed on domestic money creation and compounded liquidity tightness.
The question for investors is whether this is the optimal policy mix at a time when the US policy on quantitative easing (QE) is changing. In our view, the combination of tighter financial conditions and weak economic fundamentals in EM deficit countries will cause their underperformance to resume once the current QE relief rally ends.
While US bond yields are falling, the longer-term trend is for further increases. Standard Chartered forecasts that US 10-year Treasury yields will rise to 3.3 per cent this quarter.
India stands out positively thanks to the swift improvement in its trade deficit and the prospect of moves by the Reserve Bank of India to ease the liquidity squeeze banks are experiencing. We think that the combination of a general election, likely this year, and the growth slowdown could lead to a more accommodative policy stance from the RBI. But this will require the value of the rupee to continue to recover and inflation expectations to come back under control.
Indonesia also faces elections this year. However, in contrast to India, economic policy is unlikely to be a major feature of the election campaign. This may change as growth slows, putting pressure on margins amid elevated inflation. This may restrict the government’s ability to raise minimum wages further without undermining investment.
For investors who must remain fully invested during this period of QE transition and tight financial conditions in Asia, we recommend a focus on economies with surplus savings and no dependence on foreign liquidity to balance their books.
In Asia, these markets include Taiwan, Malaysia and the Philippines, the three with large current-account surpluses and the flexibility to maintain relatively loose domestic financial conditions.
Clive McDonnell is chief equity strategist at Standard Chartered Bank.