Europe, not EMs, at the vor­tex

Financial Mirror (Cyprus) - - FRONT PAGE - Mar­cuard’s Mar­ket up­date by GaveKal Drago­nomics

In the sum­mer of 1998, Rus­sia’s fi­nan­cial cri­sis stemmed from the oil price plunge that fol­lowed the Asian fi­nan­cial cri­sis. To­day, the worry is that Rus­sia’s fall is caus­ing a cy­cle of con­ta­gion which could pull down even de­cently man­aged emerg­ing economies. Un­usu­ally, this col­lapse is hap­pen­ing just as the world’s big­gest as­set al­lo­ca­tors pre­pare to ef­fec­tively shut up shop. It is rare to get a full blown cri­sis over year-end sim­ply be­cause vol­umes are so thin, how­ever the con­cern must be that the ab­sence of strong two-way flows in the com­ing two weeks al­lows mar­kets to gap lower in a disor­derly fash­ion. Mark-to-mar­ket re­quire­ments do not dis­ap­pear just be­cause it’s Christ­mas. Emerg­ing mar­kets are be­ing hit ir­re­spec­tive of whether they are net en­ergy ex­porters or im­porters. In­done­sia has seen its cur­rency fall back to 1998 lev­els. The po­ten­tial for an in­dis­crim­i­nate con­ta­gion can be seen in In­dia where the ru­pee has lost almost 3% in three months de­spite an im­proved ex­ter­nal po­si­tion and bet­ter in­fla­tion out­look. And then there is the po­ten­tial for events to spur an exit by for­eign in­vestors: wit­ness the po­lit­i­cal crack­down in Turkey and Thai­land’s re­cent in­tra­day 9% plunge, in part on fears of a dif­fi­cult Royal suc­ces­sion.

But for con­ta­gion to be a real threat, what is the trans­mis­sion chain? A stronger dol­lar per­haps? Cer­tainly, one can ar­gue that that the struc­tural strength­en­ing of the dol­lar means that in­vestors should avoid en­ti­ties with neg­a­tive US dol­lar cash flows. Prime can­di­dates would be high cost na­tional oil com­pa­nies, and yet look­ing across the broad EM uni­verse there is no ev­i­dence of a ma­jor blowout in credit spreads. Another risk was that the Fed­eral Re­serve would firm up its for­ward guid­ance on fu­ture in­ter­est rate rises at its lat­est FOMC meet­ing. Per­haps the sim­pler propo­si­tion is star­ing us in the face. A decade long in­vest­ment boom in the en­ergy sec­tor is com­ing to the end and in the process fi­nan­cial in­vestors are be­ing harshly squeezed. At the same time, Rus­sia faces a painful macro-eco­nomic adjustment just when it is cut off from debt cap­i­tal mar­kets due to sanc­tions. Rus­sia’s re­cent ac­tion to raise bench­mark in­ter­est rates 650bp to 17% seems likely to spark a fur­ther exit from the rou­ble. Cer­tainly, Moscow’s scope for ma­neu­ver is limited; the Cen­tral Bank of Rus­sia may have about $400 bln of for­eign ex­change re­serves re­main­ing, but about half of that is tied up in illiq­uid sov­er­eign wealth funds. The rou­ble rate hike looks like a des­per­ate ef­fort to pre­serve the liq­uid por­tion. As such, at­ten­tion is in­creas­ingly fo­cused on the po­ten­tial for a Rus­sian debt de­fault as oc­curred in 1998 – not many coun­tries have sus­tained nom­i­nal rates ap­proach­ing 20% for any pe­riod.

And this brings us to Europe which has been at the cen­tre of the storm in re­cent weeks. In the last seven trad­ing ses­sions, the main eq­uity in­dexes in France, Ger­many and Italy are lower by almost 10%. Such moves re­flect fears of re­newed po­lit­i­cal un­cer­tainty in Greece and the pos­si­ble re­turn of 2012-style sys­temic risk across the eu­ro­zone. In­vestor panic also re­flects the fail­ure of the Euro­pean Cen­tral Bank to prop­erly com­mu­ni­cate over any move to a full blown quan­ti­ta­tive eas­ing. But there is also the re­al­ity that the un­der­belly of the oil and gas boom is the Euro­pean banks. While the US shale ex­pan­sion seems to have mostly been fi­nanced via cap­i­tal mar­kets, the ex­po­sure of the Euro­pean banks to Rus­sia is not in­signif­i­cant, and it is mostly with the usual sus­pects in France and Italy which can ill af­ford another bank re­cap­i­tal­i­sa­tion.

The po­ten­tial for this mar­ket rout to morph into a more se­ri­ous fi­nan­cial cri­sis can­not be ruled out. But rather than be­ing a reck­on­ing for emerg­ing mar­kets, this looks like payback for quite spe­cific sins.

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