Fade the Emerg­ing Mar­ket rally

Financial Mirror (Cyprus) - - FRONT PAGE - By Joyce Poon

In de­fi­ance of con­ven­tional wis­dom, the oil price has tum­bled -10% in the last two weeks de­spite a weak US dol­lar. For emerg­ing mar­ket in­vestors, the break­down of this cor­re­la­tion raises tricky ques­tions. On the one hand, the worry is that EMs track the oil mar­ket into a re­newed death spi­ral as credit con­cerns again rear up, while op­ti­mists will hope that con­tin­ued US dol­lar weak­ness re­mains a sooth­ing anal­gesic, whose ef­fect over­rides all else. The an­swer to this co­nun­drum de­pends on an as­sess­ment of three key driv­ers of EM per­for­mance in re­cent years, namely, the oil price, EM fi­nan­cial con­di­tions and China’s eco­nomic outlook.

First up, EMs as a group need the oil price to stop fall­ing as its pre­cip­i­tous de­cline since July 2014 has proven to be a net neg­a­tive to global growth, rather than serv­ing as the hoped for “tax cut”. It is clear that re­sources were the sub­ject of a ma­jor cap­i­tal mis­al­lo­ca­tion episode over the last decade and the re­sult­ing neg­a­tive ad­just­ment has been most se­vere in EMs as they ben­e­fited dis­pro­por­tion­ately dur­ing the bub­ble phase.

The good news is that the oil price plunge from $110/bar­rel to a low of $30/b is spurring a pro­duc­tion re­sponse. Re­sources cap­i­tal spend­ing as a share of global GDP has al­ready fallen to 2008 lev­els. The less cheery news is that the bear mar­ket in oil prob­a­bly has a long way to run as pro­duc­tion dis­ci­pline is only be­ing ap­plied to “fu­ture” out­put. The prospect of a freeze in cur­rent out­put has foundered on the rocky ter­rain of Saudi-Iran re­la­tions, while Rus­sia is pump­ing crude at the fastest rate in al­most 30 years. As a re­sult, the oil price is likely to range-trade which low­ers the chance of an EM credit event. The is­sue for re­source-driven EMs is that they must find a new growth driver, while man­u­fac­tur­ing sup­plier economies, mostly in Asia, must find new ex­port mar­kets. Un­til such a time, EMs will trade fit­fully on the ebb and flow of the oil price.

An­other con­se­quence of the pre­ced­ing emerg­ing mar­kets boom is ex­cess cor­po­rate lever­age. As a re­sult, a delever­ag­ing dy­namic which started with com­mod­ity pro­duc­ers has spilled over to other economies through a mas­sive US dol­lar rally ver­sus EM cur­ren­cies (the re­sult of pro­duc­ers scram­bling to re­pay dol­lar debt). The good news on this front is that the risk of a US dol­lar squeeze has fallen due to the US be­ing in a phase when it is ship­ping dol­lars overseas through its trade deficit.

Still, the ap­par­ent top­ping out of the US dol­lar does not mark an end to tight fi­nan­cial con­di­tions in EMs. The liq­uid­ity pro­vided by the wider US trade deficit low­ers the chance of an out­right crunch, but at this stage is not enough to boost growth. Debt ser­vic­ing re­mains painful as in­come growth has been weak. Even for EM man­u­fac­tur­ing ex­porters, times re­main hard as global trade has merely tracked global growth, while con­tin­ued high ca­pac­ity across a range of sec­tors has eroded their pric­ing power. By the end of 2015, the ag­gre­gate debt-serv­ing bur­den in emerg­ing economies had risen to match that in de­vel­oped economies, while the same ra­tio for the pri­vate non-fi­nan­cial sec­tor has surged be­yond the peak reg­is­tered in the 2008 global cri­sis. As a re­sult, EMs re­main vul­ner­a­ble to any neg­a­tive shift in global mar­ket psy­chol­ogy; such an out­come is easy to see since in­vestors, per­haps op­ti­misti­cally, ex­pect less than one US in­ter­est rate hike this year.

Of the three fac­tors, China is the only one where the stars seem to be align­ing pos­i­tively, at least on a tac­ti­cal ba­sis. The worst pe­riod of cap­i­tal out­flows has passed.

Mean­while, de­mand-side pol­icy, such as faster credit cre­ation and an en­gi­neered re­bound in the prop­erty mar­ket is un­fold­ing. Prices of build­ing ma­te­ri­als have re­bounded, es­pe­cially ce­ment which is par­tic­u­larly sen­si­tive to fi­nal de­mand. My con­cern re­mains that any cycli­cal re­cov­ery, spurred by stim­u­lus spend­ing, will ul­ti­mately prove dam­ag­ing if the pri­vate sec­tor does not get a full star­ring role. Thus far, the worry lingers: cap­i­tal spend­ing growth in the first two months of the year was driven by state-sec­tor spend­ing ris­ing 20% while pri­vate sec­tor in­vest­ment growth has slowed to 5%.

As a re­sult volatil­ity is likely to re­main the buzz-word for EMs. Ex­pect con­tin­ued vi­o­lent ral­lies and sell-offs like those seen since the start of the year, with key fac­tors be­ing in­vestor po­si­tion­ing. While the mas­sive un­der­per­for­mance of EMs may have passed its nadir, this does not sig­nal the start of a new sec­u­lar bull mar­ket.

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