Emerging markets, tapering and conspiracy theories

by George Hatjoullis

USD BrazilUSD IndiaUSD Turkey

It is now almost a year since I had access to a Bloomberg terminal. I was somewhat taken aback by the immoderate tone of this Bloomberg comment article by Jeffrey Goldberg (http://bloom.bg/178k3Qx). Not what I had become accustomed to in the last 30 or so years. Not that I have any issue with Mr Goldberg’s complaint. The idea that the Turkish economy is under attack from an anti-Islam interest rate lobby is absurd.

The Turkish Lira falls into the category of ‘emerging market‘ and all markets in this category have had a very bad time since the tapering narrative appeared on the scene late in May. The above charts, all courtesy of IG index, illustrate the point perfectly. The Brazil, India and Turkey currencies versus the US Dollar all exhibit much the same trend. Other emerging (submerging) market currencies exhibit the same pattern.

The problem is, of course, that the emerging markets are very illiquid. A lot of cash looking for a home after the 2008 financial crisis found its way into these markets. There was even talk of emerging market assets being the new ‘risk free’ asset class. Such narratives always emerge to justify taking investment decisions that deep down everyone knows are ill-considered. When you hear ‘it is different this time’ it is best to go elsewhere. Those that recognise the risks console themselves that are going along for the ride and will get off when it gets dangerous. This misses the nature of the risk; you cannot get off.

The emerging markets have absorbed portfolio flows well in excess of the capacity of these economies to productively employ. The flows overvalued assets and created huge book profits. A few have realised profits selling on to a new, or greedy, international investor. However, to whom does one sell when all international investors seek to exit? It is analogous to everyone trying to go out through a revolving door at once. It can get messy and prices can fall as precipitously as they rose. What goes down can go down a lot further.

The event that precipitated the EM collapse was the prospect of tapering by the Federal Reserve. This prospect affected all markets as has been discussed ad nauseam in previous blogs. The disproportionate reaction of these markets can be explained by illiquidity. However, it is believed that EM markets benefitted disproportionately from the easy-money environment that has prevailed since 2008. They are also expected to suffer disproportionately in the aftermath of tapering. The asset price deflation being experienced may not yet be over.