Emerging Asia ex-China – prospects for growth – Currency – Stocks and Bonds

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Macro Letter – No 12 – 23-05-2014

Emerging Asia ex-China – prospects for growth – Currency – Stocks and Bonds

As Chinese growth slows will the rest of Emerging Asia falter?

Will Emerging Asia close the gap which has opened relative to developed markets?

Which Emerging Asian markets offer the best value?

As the world economy continues its slow recovery from the great recession the developed economies have been taking over the reins of growth from the emerging markets. This has been clearly illustrated by the under-performance of the MSCI Emerging Market Equity Index compared to the S&P500; the PE differential between EEM index and the S&P is near to levels last seen in 1997. Emerging equity markets are currently trading at their largest discount to developed markets in more than a decade. Historically when the EM equity price to book ratio is below 1.5 – which is currently the case – the next year sees double digit returns.

MSCI EM vs S&P - 5 yr - Yahoo Finance

Source: Yahoo Finance

This five year chart shows the initial “lock-step” recovery during the early phase of the recovery. After the Eurozone crisis the two markets diverged despite significant capital flows into emerging markets.

The emerging markets share of global GDP is forecast to rise to 40% by 2018 – it was just 10% in 2003. However, EM equities account for only 11% of global market capitalisation.

During 2013 the disappointing performance of emerging market equities spilled over onto the foreign exchange market with several Asian currencies declining precipitously.

The Indian Rupee led the charge followed by the Indonesian Rupiah this prompted aggressive tightening of monetary policy by the Reserve Bank of India and Bank Indonesia. Thailand, Malaysia and the Philippines all suffered by association as foreign capital was withdrawn. However, EM central banks learnt from the Asian crisis of 1997/98 – their foreign currency reserves have increased from 16% of GDP in 1997 to 37% in 2013. The BIS – Foreign exchange intervention and the banking system balance sheet in emerging market economies – March 2014 offers a fascinating insight into this development and its impact on EM economies. They conclude that EM CB FX intervention amounts to an “Impossible Trinity” weakening their control over domestic monetary policy and increasing risks to the financial system.

The charts below are inverted but show the relative performance of the Emerging Asian currencies during the past year. China, of course, is the odd man out due to their peg against the US$.

THB blue - PHP purple - MYR light blue - 1 year - bloomberg 

THB – Blue, PHP – Purple, MYR – Light Blue                    Source: Bloomberg

INR blue - IDR purple - CNH light blue 1 yr - bloomberg 

INR – Blue, IDR – Purple, CNY – Light Blue                       Source: Bloomberg

These currencies have now stabilised but at lower levels thanH1 2013, however, Emerging and Developed Asia is the region of strongest forecast economic growth according to most commentators. The IMF 2014 forecasts for the region have changed little in the past year: –

Country Jul-13 Oct-13 Jan-14 Apr-14
World 3.8 3.6 3.7 3.6
Dev Asia 7 6.5 6.8 6.8
China 7.7 7.3 7.5 7.5
India 6.2 5.1 5.4 5.4
Asean 5* 5.7 5.4 5.1 4.9
* Includes Indonesia, Thailand, Malaysia, Philippines and Vietnam

Source: IMF

The latest IMF – World Economic Outlook – April 2014 is entitled “Recovery Strengthens, Remains Uneven”. Here is how they sum up the prospects for Emerging Markets:-

First, if growth in advanced economies strengthens as expected in the current WEO baseline forecasts, this, by itself, should entail net gains for emerging markets, despite the attendant higher global interest rates. Stronger growth in advanced economies will improve emerging market economies’ external demand both directly and by boosting their terms of trade. Conversely, if downside risks to growth prospects in some major advanced economies were to materialize, the adverse spillovers to emerging market growth would be large. The payoffs from higher growth in advanced economies will be relatively higher for economies that are more open to advanced economies in trade and lower for economies that are financially very open.

Second, if external financing conditions tighten by more than what advanced economy growth can account for, as seen in recent bouts of sharp increases in sovereign bond yields for some emerging market economies, their growth will decline. Mounting external financing pressure without any improvement in global economic growth will harm emerging markets’ growth as they attempt to stem capital outflows with higher domestic interest rates, although exchange rate flexibility will provide a buffer. Economies that are naturally prone to greater capital flow volatility and those with relatively limited policy space are likely to be affected most.

Third, China’s transition into a slower, if more sustainable, pace of growth will also reduce growth in many other emerging market economies, at least temporarily. The analysis also suggests that external shocks have relatively lasting effects on emerging market economies, implying that their trend growth can be affected by the ongoing external developments as well.

Finally, although external factors have typically played an important role in emerging markets’ growth, the extent to which growth has been affected has also depended on their domestic policy responses and internal factors. More recently, the influence of these internal factors in determining changes in growth has risen. However, these factors are currently more of a challenge than a boon for a number of economies. The persistence of the dampening effects of these internal factors suggests that trend growth is affected as well. Therefore, policymakers in these economies need to better understand why these factors are suppressing growth and whether growth can be strengthened without inducing imbalances. At the same time, the global economy will need to be prepared for the ripple effects from the medium-term growth transitions in these emerging markets.

 As China reforms and rebalances its economy towards domestic consumption, how will the other countries of Emerging Asia perform and what will this mean for their financial markets?

The table below highlights some aspects of these markets. They are arranged in GDP size order: –

 

Country GDP 2014 f/c* 2015 f/c Base Rate 10yr Bond** Inflation Unemploy Gov Budget Debt/GDP C/A
India 4.7 5.8 6.5 8 8.78 8.31 3.8 -4.9 68 -4.6
Indonesia 5.7 5.3 5.5 7.5 8.02 7.25 6.25 -2.2 26 -3.2
Thailand 0.6 4.5 5 2 3.39 2.45 0.62 -2.5 45 -0.4
Malaysia 5.1 4.8 4.9 3 4 3.5 3.2 -3.9 55 4.7
Philippines 6.5 6.5 7.1 3.5 4.31 3.9 7.5 -1.4 38 3.5
* Forecasts World Bank – GEP – January 2014
** Source: Investing.com (15/5/2014)

The World Bank GDP forecasts differ slightly from those of the IMF but not materially. All the countries are saddled with budget deficits but Malaysia and the Philippines are running current account surpluses. Indonesia’s Debt to GDP ratio is the lowest of the five nations but their debt is heavily US$ denominated whereas Thailand is principally a domestic borrower.

Below I’ve picked out some details from the IMF – World Economic Outlook:-

1. Deviation from Trend GDP

India is running around 3.5% below trend and Thailand 2% below, Malaysia is fairly neutral but Indonesia is already around 1.5% above trend and the Philippines nearly 2.5% above.

2. Responsiveness to US GDP shock

India is most sensitive at +/- 2%, followed by Malaysia 1.5%. The Philippines moves one for one and in the first year Thailand barely reacts, although in year two its sensitivity increases to +/- 0.6%.

3. Trade Openness (Exports plus Imports as a % of GDP)

Malaysia comes top at 175%, followed by Thailand at around 130%, then the Philippines at 80%, Indonesia at 60% and finally India at 45%

4.Trade exposure to advanced economies (Exports to US and EU as % of GDP)

Malaysia leads once again with 28%, followed by Thailand at 17%. The Philippines are hot on their heels at 15% whilst Indonesia and India languish at 8% and 5% respectively.

5. Foreign Capital flow volatility

Malaysia is most sensitive at 5%, followed by Thailand at 4.5%. Indonesian volatility is around 3% whilst the Philippines is only 2%. India has the least sensitivity at 1.8%.

India 

After China, India is the largest economy in Emerging Asia. With 1.2 bln people it is blessed with the most favourable demographics of the BRIC economies. It should overtake China to become the most populous country on earth between 2020 and 2025. In the nearer term Indian voters have just elected a new BJP government with a strong reform agenda. I’m not sure that “Toilets not Temples” is the greatest campaign slogan but it clearly resonated with the masses.

India suffered from capital flight in 2013 with the INR declining by 17% against the US$. After the initial Federal Reserve tapering announcement on 3rd September 2013 capital outflows totalled $13.4bln and RBI reserves were depleted to the tune of $17bln. The RBI responded by raising the Marginal Standing Facility by 2%. They then reduced it by 150bp as the short term effect of capital flight subsided. Rates were then increased by 75bp as inflation concerned increased.

The RBI – Macro and Monetary Developments April 2014 report shows how the Indian economy has recovered over the last few months. It goes on to identify risks and opportunities looking ahead: –

 The Indian economy is set on a disinflationary path, but more efforts may be needed to secure recovery

I.6 While the global environment remains challenging, policy action in India has rebuilt buffers to cushion it against possible spillovers. These buffers effectively bulwarked the Indian economy against the two recent occasions of spillovers to EMDEs — the first, when the US Fed started the withdrawal of its large scale asset purchase programme and the second, which followed escalation of the Ukraine crisis. On both these occasions, Indian markets were less volatile than most of its emerging market peers. With the narrowing of the twin deficits – both current account and fiscal – as well as the replenishment of foreign exchange reserves, adjustment of the rupee exchange rate, and more importantly, setting in motion disinflationary impulses, the risks of near-term macro instability have diminished. However, this in itself constitutes only a necessary, but not a sufficient, condition for ensuring economic recovery. Much more efforts in terms of removing structural impediments, building business confidence and creating fiscal space to support investments will be needed to secure growth.

I.7 Annual average CPI inflation has touched double digits or stayed just below for the last six years. This has had a debilitating effect on macro-financial stability through several channels and has resulted in a rise in inflation expectations and contributed to financial disintermediation, lower financial and overall savings, a wider current account gap and a weaker currency. A weaker currency was an inevitable outcome given the large inflation differential with not just the AEs, but also EMDEs. High inflation also had adverse consequences for growth. With the benefit of hindsight, it appears that the monetary policy tightening cycle started somewhat late in March 2010 and was blunted by a series of supply-side disruptions that raised inflation expectations and resulted in its persistence. Also, the withdrawal of the fiscal stimulus following the global financial crisis was delayed considerably longer than necessary and may have contributed to structural increases in wage inflation through inadequately targeted subsidies and safety net programmes.

I.8 Since H2 of 2012-13, demand management through monetary and fiscal policies has been brought in better sync with each other with deficit targets being largely met. Monetary policy had effectively raised operational policy rates by 525 basis points (bps) during March 2010 to October 2011. Thereafter, pausing till April 2012, the Reserve Bank cut policy rates by 75 bps during April 2012 and May 2013 for supporting growth. Delayed fiscal adjustment materialised only in H2 of 2012-13, by which time the current account deficit (CAD) had widened considerably.

The easing course of monetary policy was disrupted by ‘tapering’ fears in May 2013 that caused capital outflows and exchange rate pressures amid unsustainable CAD, as also renewed inflationary pressures on the back of the rupee depreciation and a vegetable price shock. The Reserve Bank resorted to exceptional policy measures for further tightening the monetary policy. As a first line of defence, short-term interest rates were raised by increasing the marginal standing facility (MSF) rate by 200 bps and curtailing liquidity available under the liquidity adjustment facility (LAF) since July 2013. As orderly conditions were restored in the currency market by September 2013, the Reserve Bank quickly moved to normalise the exceptional liquidity and monetary measures by lowering the MSF rate by 150 bps in three steps. However, with a view to containing inflation that was once again rising, the policy repo rate was hiked by 75 bps in three steps.

I.9 Recent tightening, especially the last round of hike in January 2014, was aimed at containing the second round effects of the food price pressures felt during June-November 2013. Since then, inflation expectations have somewhat moderated and the temporary relative price shock from higher vegetable prices has substantially corrected along with a seasonal fall in these prices, without further escalation in ex-food and fuel CPI inflation. While headline CPI inflation receded over the last three months from 11.2 per cent in November 2013 to 8.1 per cent in February 2014, the persistence of ex-food and fuel CPI inflation at around 8 per cent for the last 20 months poses difficult challenges to monetary policy.

I.10 Against this background there are three important considerations for the monetary policy ahead. First, the disinflationary process is already underway with the headline inflation trending down in line with the glide path envisaged by the Urjit Patel Committee, though inflation stays well above comfort levels.

Second, growth concerns remain significant with GDP growth staying sub-5 per cent for seven successive quarters and index of industrial production (IIP) growth stagnating for two successive years. Third, though a negative output gap has prevailed for long, there is clear evidence that potential growth has fallen considerably with high inflation and low growth. This means that monetary policy needs to be conscious of the impact of supply-side constraints on long-run growth, recognising that the negative output gap may be minimal at this stage.

What does this mean for the INR, Indian stocks and Indian Bonds?

The Sensex Index is already trading on a P/E of 17. This is expensive when compared to the EM average of 12. Therefore they do not offer exceptional value, however, Indian equities are making new highs, the uncertainty of the elections is behind them and world equity markets continue higher – stay long!

Indian Bonds are not easy for international investors to access and offer a real yield of only 0.47%. The Indian yield curve is positive to the tune of 0.78% but inflation expectations are falling. Whilst there are better real yields and steeper yield curves in Emerging Asia, Indian Bonds should perform well as the new government embarks on economic reform.

The USD/INR hit its low point in August 2013 at 69.25 but has since rallied to 58.38 this month; this is still in the lower end of its post 2009 range and well below 2005-2009 levels. I expect the INR to appreciate as the Modi government gets to work. This may dampen the rise of the Sensex.

The Sensex Index has rallied by more than 40% since its low in August 2013, taking out previous highs. The INR has also performed strongly but is still well below its 2010/2011 level of sub 50 vs USD. Indian 10yr bonds by contrast have seen yields increase from 7.2% in June 2013 to hit their highs at 9.17% in December last year. Since then they have increased slowly to their current yield of 8.78%. Technically they look uninteresting but fundamentally they should perform well – this is one of the highest yields in emerging markets.

Indonesia

Indonesia suffered from similar issues to India as the latest Bank Indonesia – Monetary Policy Review – April 2014 explains:-

At the Bank Indonesia Board of Governors’ Meeting held on 8th April 2014, it was decided to maintain the BI rate at 7.50%, with the Lending Facility rate and Deposit Facility rate held respectively at 7.50% and 5.75%. This policy is consistentwith ongoing efforts to steer inflation back towards its target corridor of 4.5±1% in 2014and 4.0±1% in 2015, as well as reduce the current account deficit to a more sustainablelevel. Bank Indonesia considers recent developments in the economy of Indonesia asfavourable and in line with previous projections, marked by lower inflation and a balance oftrade that has returned to record a surplus. Looking ahead, Bank Indonesia will continue toremain vigilant of a variety of risks, globally and domestically, as well as implement anticipatory measures to ensure economic stability is preserved and stimulate the economy in a more balanced direction, thereby buoying current account performance. To this end, Bank Indonesia will continue strengthening the monetary and macroprudential policy mix as well as enhancing coordination with the Government to control the rate of inflation and reduce the current account deficit, including policy to bolster the structure of the economy and manage external debt, in particular private external debt.

…Bank Indonesia expects the ongoing episode of domestic economic moderation to continue, leading to a more balanced and sound economic structure. Externaldemand is improving and substituting moderating domestic demand as a source ofeconomic growth. Several latest indicators and leading indicators demonstrate thathousehold consumption surged in the first quarter of 2014 in the run up to the 2014General Election, among others. Exports are also following a more favourable trend on theback of exports from the manufacturing sector in harmony with the economic recoveriesreported in advanced countries. Meanwhile, private investment growth during the firstquarter of 2014 remained limited and is not expected to pick up until the second semester.As a whole, economic growth in Indonesia for 2014 remains in the range projected previously by Bank Indonesia at around 5.5-5.9%.

More balanced economic growth is further buttressed by improvements in the external sector from the standpoint of the trade balance and the financial account. The balance of trade of Indonesia in February 2014 rebounded to record a surplus of US$0.79 billion, bolstered by a burgeoning surplus in the non-oil/gas trade account. Thegrowing surplus in the non-oil/gas account stemmed from a contraction in non-oil/gas imports in line with moderating domestic demand along with a surge in non-oil/gasexports, primarily from the manufacturing sector as the economies of advanced countriescontinue to recover. The trade surplus also emanated from reductions in the oil and gastrade deficit as a result of rising oil and gas exports due to increased oil lifting as well as adecline in oil and gas imports in accordance with the mandatory use of biodiesel as fuel inthe transportation sector and the electricity sector. In terms of the financial account,foreign capital inflows continued unabated in March 2014, thus foreign portfolio inflows tofinancial markets in Indonesia reached US$ 5.8 billion accumulatively in the first quarter of2014. Against this auspicious backdrop, foreign exchange reserves held in Indonesia at theend of march 2014 topped US$ 102.6 billion, equivalent to 5.9 months of imports or 5.7months of imports and servicing external debt, which is well above international adequacystandards of around three months of imports. Looking forward, Bank Indonesia expectsimprovements in the external sector to continue, underpinned by a current account deficitin 2014 that can be brought down to below 3.0% of GDP and a deluge of foreign capitalinflows. To this end, Bank Indonesia will continue to monitor a plethora of risks, global anddomestic, which could undermine external sector resilience and its pertinent response,including the performance of external debt, in particular private eternal debt.

The rate of inflation continued a downward trend in March 2014, which further  supports the prospect of achieving the inflation target of 4.5±1% in 2014. The rateof headline inflation was low in March 2014 at 0.08% (mtm) or 7.32% (yoy), down on thatposted in February 2014 at 0.26% (mtm) or 7.75% (yoy). Furthermore, inflation in Marchwas also lower than the average rate over the past six years. Inflationary pressures eased as a result of lower core inflation, which dropped in line with exchange rate appreciation, moderating domestic demand and well-anchored inflation expectations. Furthermore, food prices also experienced deflation due to greater supply of several food commodities at the onset of the harvest season.

 

An overall moderation in growth and inflation but an increasing trade surplus due to improved export demand. This, together with inward capital flows has supported Indonesian stocks, bonds and the IDR.

Another major factor for Indonesia is the forthcoming presidential elections, scheduled for July. The lead candidate, Jokowi, appears to be a reformer but details of his policies are only beginning to take shape as this Lowy Institute article describes.

The IDX Index made its recent lows in August 2013 – a 27% fall from its May 2013 highs. Since then the market has recovered. This month it came within 2.7% of the May 2013 high. If long: stay long. If not, wait for a close above 5,231.

Indonesian Bonds have shown little significant strength. As recently as February 2014 they made new highs at 9.24%. This is a significant increase on their low point of 5.08% in January 2013. Technically they look neutral. Since the 2008 crisis when they briefly touched 21.10% they have risen substantially. After a brief decline to test 9.96% in January 2011 they have been driven by international capital flows. With a lower yield than India and a more volatile history during the 2008/2009 crisis I’m inclined to wait for confirmation – going long on a break below the October 2013 low of 6.92% or short, if you can secure the repo, above the February 2014 high of 9.24%.

During the 2008/2009 crisis the IDR declined from 9000 to 12500 vs US$. It then recovered to pre-crisis levels and only began the recent depreciation in 2012. The precipitous deterioration began in July 2013 when it broke through 10000. The low point occurred in January of this year at 12200. Since then the IDR has regained some ground but the recovery still appears tentative.

The relative weakness of the IDR will aid Indonesia’s export competitiveness. Many investors choose to purchase US$ denominated Indonesian bonds so foreign capital is most likely to flow into the Indonesian stocks. 

Thailand

Thailand has seen rapidly slowing growth, prompting the Bank of Thailand to cut interest rates again in March. The Bank of Thailand – Monetary Policy Report – March 2014 elaborates: –

 The Thai economy appeared poised to slowdown in 2014 due to weaker domestic demand during the first half of the year. This was due to the political situation in Thailand which dented consumer and investor confidence. Meanwhile, exports gradually recovered in line with improved trading partners’ economies. Nevertheless, should the political situation subside by mid-2014, domestic demand was expected to pick up and would be the driver of economic growth together with exports. As a consequence, the Thai economy would resume growing close to its normal pace in 2015. Meanwhile, inflationary pressure edged up mainly from the pass-through of LPG cost to food prices, while demand pressure softened in line with economic conditions.

In the past three meetings, the MPC voted to reduce the policy rate by 0.25 percent in the first meeting, hold the policy rate at 2.25 percent per annum in the following meeting and then voted to reduce the policy rate by another 0.25 percent to stand at 2.00 percent per annum in the latest meeting. The MPC deemed that there was room for monetary policy to ease in order to lend more support to the economy during the recovery period, while inflationary pressure was not yet a concern.

The slowing of the Thai economy is also reflected in the weak performance of the USD/THB. From its recent high at 29.48 it sank to a low point of 33.15 in January this year – it has failed to stage much of a recovery since then.

Thai Bonds made a recent high in May 2013 at 3.29%. During the capital repatriation, yields backed up to 4.50% but have since fallen back to 3.39% – testament to the weakness of economic conditions.

The SET Index, by contrast has followed the global trend since making a low in January. It remains some distance below its May 2013 high. If the THB remains weak then the SET Index should benefit but the continued political unrest is likely to sap international enthusiasm for investment. This Bloomberg Business Week article may be useful by way of background.

 Malaysia

Those who remember the Asian crisis of 1997 will recall that Malaysia took the decision to impose foreign exchange controls. At the time many market participants forecast the demise of the Malaysian economy. They were proved incorrect, however, the risk that an investment cannot be liquidated and the proceeds repatriated, still hangs over Malaysian financial markets. This is a double-edged sword; volatility in MYR remains significantly lower than for IDR or INR. According to the IMF Malaysia has the greatest sensitivity to Capital Flows of the Emerging Asia countries. The price action of the past few years suggests this may no longer be the case.

After the removal of exchange controls in 2005 the MYR quickly appreciated from USD/MYR 3.8 to around 3.20 by mid-2008. The crisis saw the currency fall briefly to 3.70. By mid-2011 it was touching 3.00. The 2013 “tapering-tantrum” took the rate back to 3.46 in January 2014 but this year it has followed the other Asian currencies, recovering its composure.

But what are the prospects for the Malaysian economy? This monthsBank Negara Malaysia – Monetary Policy Statement – May 2014 provides a good overview: – 

Global growth moderated in the first quarter with several key economies affected by weather-related and policy-induced factors. Looking ahead, the global economy is expected to remain on a path of gradual recovery. In Asia, the better external environment provides further support to growth amid continued expansion in domestic demand. Conditions in the international financial markets have also improved following gradual and orderly policy adjustments in the major advanced economies while the impact from geopolitical developments remains contained.

For Malaysia, latest indicators suggest that the domestic economy continued to register favourable performance in the first quarter. Going forward, growth will remain anchored by domestic demand with additional support from the improved external environment. Exports will continue to benefit from the recovery in the advanced economies and regional demand. Private sector spending is expected to remain robust. Investment activity is supported by broad-based capital spending, particularly in the manufacturing and services sectors. Private consumption will be underpinned by stable income growth and favourable labour market conditions. The prospects are therefore for the growth momentum to be sustained.

Inflation has stabilised in recent months amid the more favourable weather conditions and as the impact of the price adjustments for utilities and energy moderate. Going forward, inflation is, however, expected to remain above its long-run average due to the higher domestic cost factors.

Amid the firm growth prospects and inflation remaining above its long-run average, there are signs of the continued build-up of financial imbalances. While the macro and micro prudential measures have had a moderating impact on the growth of household indebtedness, the current monetary and financial conditions could lead to a broader build up in economic and financial imbalances. Going forward, the degree of monetary accommodation may need to be adjusted to ensure that the risks arising from the accumulation of these imbalances would not undermine the growth prospects of the Malaysian economy.

Moderate growth, stable, but above target, inflation and risks of further inflationary pressure ahead; not the most compelling grounds for investment. This doesn’t appear to have dampened enthusiasm for Malaysian stocks. The KLCI Index has barely looked back since the 2008/2009 crisis. It witnessed a small correction in the fall of 2011 and an even smaller one during the summer of 2013. This month it took out the December 2013 highs. From a technical perspective one should remain long and be adding to that exposure. The Bank Negara report, however, prompts some caution.

Malaysian Bonds also reflect the central bank’s cautious tone. Having made post crisis lows at 3.06% in May 2013 the bond market fell during the second half of 2013 to peak at 4.31% in January. Since then the yield has fallen moderately. At the current yield (4%) even with a 1% positive yield curve I don’t perceive much attraction at this level.

Philippines

The Philippines suffered an appalling natural disaster last year when Typhoon Haiyan unleashed its wrath. It caused an estimated $770mln of damage but I don’t believe this was enough to derail what looks to be a strong growth story. According to the IMF it is above its trend growth rate, but inflation seems under control and the political will to reform the underperforming aspects of the economy seem to be in place. The Bangko Sentral ng Pilipinas – Q1 2014 Inflation Report takes up the story:-

Headline inflation rises on higher food and nonfood inflation. y) headline inflation ‐s inflation target range of 1.0 ppt for 2014. The uptick in headline inflation could be attributed to higher food inflation as the prices of most food commodities increased owing to some tightness in the domestic supply conditions. Similarly, higher electricity rates and domestic petroleum prices contributed to food inflation. The official core inflation along with two out of three alternative measures of core inflation estimated by the BSP likewise rose in Q1 2014 relative to the rates registered in the previous quarter. The official core inflation was slightly higher at 3.0 percent during the review quarter from 2.9 percent in Q4 2013. The number of items with inflation rates greater than the threshold of 5.0 percent also increased and accounted for a higher proportion of the CPI basket.

Domestic demand conditions remain buoyant. The Philippine economy continued to expand at an year 2013 GDP growth to 7.0 percent for the year. Output growth was driven by robust household spending, exports, and capital formation (particularly durable equipment) on the expenditure side; and by solid gains in the services sector on the production side. At frequency demand indicators continued to show positive readings in the first quarter. Vehicle sales posted strong growth during the quarter, buoyed by brisk consumer demand and attractive financing options offered by industry players. Energy sales also continued to rise, albeit at a slower pace, on account of increased consumption by the industrial and commercial sectors, while capacity utilization in manufacturing is steady above 80 percent. The composite Philippine Purchasing expansion threshold at 58.2 in Q4 2013 levels. Similarly, the outlook of businesses and consumers for the following quarter turned more favorable, supporting the continued strength of aggregate demand in the coming months amid sustained credit growth and ample liquidity in the financial system.

…Local financial markets experience bouts of volatility but regain some stability. s tapering of its quantitative easing (QE) measures and potential abrupt adjustments in its policy stance as recovery in the US firms up. Indications of a further economic slowdown in China likewise quarter owing to positive domestic economic reports suggesting sustained resiliency of Philippine macroeconomic fundamentals along with expectations of continued strong corporate earnings. The US Fed pronouncement to scale back stimulus in measured steps further propelled optimism in the local s average, while the spread on Philippine credit default swaps (CDS) continued to trade lower relative to those of our neighbors in the region. The Philippine Stock Exchange index (PSEi) also began to recover gains lost in bill auctions during preference bills. However, the peso recorded moderate depreciation relative to previous quarter on lingering uncertainty on the external front.

Inflation expectations continue to support the withintarget inflation outlook. s target 2015. Analysts expect inflation to rise going forward due largely to factors such as pending electricity rate adjustments, weakening peso, and possible increases in food and oil prices. Results of the March 2014 Consensus Economics inflation forecast survey for the country also showed a higher mean inflation projection for 2014.

The BSP maintains key policy rates but adjusts the reserve requirement ratio. The BSP decided to keep its policy interest rates steady during its 3 February and 27 March 2014 monetary policy meetings on the assessment that the future inflation path was likely to stay within the target ranges of 1.0 ppt for 2015. At the same time, the MB decided to increase the reserve requirement by one ppt effective on 11 April 2014 to help guard against potential risks to financial stability that could arise from the recent rapid growth in domestic liquidity.

Prevailing monetary conditions and inflation dynamics suggest that the space to keep monetary policy settings unchanged is narrowing. Latest baseline projections continue to show average headlineinflation settling within the target ranges for 2014 and 2015. However, current assessment of the priceenvironment over the policy horizon indicates that the balance of risks to the inflation outlook remainstilted to the upside, with potential price pressures emanating from pending petitions for adjustments inutility rates and from possible increases in food and oil prices. At the same time, while inflation expectations are still within target, they have trended higher and are moving near the upper end of the target range for 2015. Firm growth dynamics arising from the broad buoyancy of domestic demand also suggest that the economy can accommodate measured adjustments in monetary conditions. trust account placements in the SDA facility in November with more loanable funds deployed to support domestic economic activity as evident by the robust growth in bank lending. The continued strong liquidity up of financial stability risks. On the whole, the BSP continues to have monetary policy space to address the challenges that could threaten the inflation objective and stability of the Philippine financial system.

Going forward, the BSP will remain guided by its primary objective of maintaining price stability along with safeguarding the resilience of the financial system, and stands ready to deploy appropriate measures as needed to ensure sustainable, non‐inflationary, and inclusive economic growth.

The USD/PHP exchange rate remains weak but the overall decline in the PHP was less dramatic than for some of its Emerging Asia neighbours. From a March 2013 high of 40.40 it weakened to just above 46 by March this year. It is currently around 43.60. This should benefit the Philippine equity market.

The PSEI Index, however, has some way to go before breaching its May 2013 high at 7403. The technical picture looks similar to Thailand and Malaysia but the economic fundamentals are more supportive. At 6900 the index still presents a buying opportunity.

The Philippine Bond market doesn’t present such an obvious opportunity. After making highs this time last year at 3.04% yields had risen to 4.63% by March of this year. Now at 4.31% they offer the lowest real yield of the group.

Conclusion

International capital is flowing back into emerging Asia. A World Bank study earlier this year found that 60% of the investment in emerging markets between 2009 and 2013 has been due to quantitative easing and related policies of developed country central banks. The Bank of Japan continue with the Three Arrows – I hear rumours of more radical policies to come. The Fed is still adding $55bln per month. The ECB may be ready to do there bit for European growth. The Basel III rules are being gradually diluted – which, through the multiplier effect, may eclipse any reduction of QE by the Fed. In this environment Emerging Asia should benefit from inward capital flows and growth in exports to the recovering economies of the US, UK and even some parts of Europe. China will continue to rebalance toward consumption but its neighbours should benefit longer-term; I would anticipate an increase in capital expenditure by Asian companies in expectation of greater consumer demand from China.

My favoured equity market is the Philippines followed by India. My favoured bond market is India on the grounds that it offers the highest nominal yield in this group of emerging markets. As for the top currency, again I choose India. The INR and IDR will both benefit from the carry trade, but India is a larger and more balanced economy. It is therefore more insulated from concerns about a commodity collapse as China’s economy slows.

Emerging Markets and disinflation in developed economies

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Macro Letter – No 5 –14-02-2014
Emerging Markets and disinflation in developed economies

Introduction

Emerging markets have become the focus of attention since the beginning of the year. Many articles have appeared anticipating a repeat of the 1997 Asian crisis but I believe the effects of globalisation and the low levels of inflation in the developed world mean that though a broad crisis might ensue it is more likely that a major crisis will be averted, at least for the present.

Since the second half of 2013 one of the greatest risks to a sustained economic recovery in the developed economies has been the stability of emerging markets. Last year concerns began to emerge with a collapse in the INR, but soon spread to other emerging market currencies. This led a number of commentators to identify the “Fragile Five”; Brazil, India, Indonesia, South Africa, Turkey. The basis for this epithet was: –

1. Twin budget and current account deficits
2. Falling growth
3. Above target inflation
4. Some form of political uncertainty

Further candidates for inclusion based on political factors include: Argentina, Hungary, Thailand, Ukraine and Venezuela – the “Vulnerable Five”.
In this letter I want to look at emerging markets in general. To begin it is worth reviewing world economic growth over the past two decades and forecasts for the next few years. Below is a table of GDP Growth extracted from the IMF World Economic Outlook – October 2013:-

GDP growth              Average                                                                                           Projections
Year                              1995–2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2018
World                                  3.6         4.7      5.2     5.3      2.7   –0.4  5.2     3.9    3.2     2.9     3.6    4.1
Advanced Economies      2.8         2.8      3.0    2.7      0.1    –3.4  3.0     1.7     1.5     1.2      2.0   2.5
Central/East Europe        4.0         5.9      6.4    5.4      3.2   –3.6  4.6     5.4     1.4     2.3     2.7    3.7
CIS                                       2.9         6.7       8.8   8.9      5.3   –6.4  4.9     4.8     3.4     2.1     3.4    3.7
Developing Asia                7.1          9.5      10.3  11.5     7.3      7.7   9.8     7.8     6.4    6.3     6.5    6.7
Lat Am and Caribbean    2.5          4.7       5.6    5.7      4.2  –1.2    6.0     4.6     2.9    2.7     3.1    3.7
MENA                                 4.6          5.5       6.8   5.9      5.0     3.0   5.5      3.9     4.6    2.1     3.8   4.4
Sub-Saharan Africa          4.5          6.3       6.4   7.1       5.7     2.6   5.6      5.5     4.9    5.0     6.0   5.7

Source: IMF

Perhaps a more useful guide to GDP is to be found in the deflated Real GDP data – again extracted from IMF WEO – October 2013: –

Real GDP data         Average                                                                                          Projections
Year                             1995–2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2018
Advanced Economies      2.8          2.8      3.0     2.7     0.1    –3.4   3.0     1.7    1.5    1.2     2.0      2.5
Central/East Europe       4.0          5.9      6.4      5.4     3.2    –3.6   4.6     5.4   1.4    2.3    2.7      3.7
CIS                                      2.9           6.7      8.8     8.9     5.3     –6.4  4.9     4.8   3.4    2.1    3.4      3.7
Developing Asia               7.1           9.5     10.3    11.5    7.3        7.7   9.8     7.8   6.4   6.3    6.5      6.7
Lat Am and Caribbean   2.5           4.7      5.6      5.7     4.2    –1.2    6.0     4.6   2.9   2.7    3.1      3.7
MENA*                              4.6          6.0      6.7      5.9     5.0      2.8    5.2     3.9    4.6   2.3    3.6     4.4
Sub-Saharan Africa         4.5          6.3      6.4      7.1      5.7      2.6    5.6     5.5    4.9    5.0    6.0    5.7

Source: IMF

*MENA includes Afghanistan and Pakistan

This analysis suggests that developing Asia will continue to lead the way followed by MENA and the frontier markets of Africa. Whilst this may be useful for tactical asset allocation it tells us little about the size of the economies in question.

To address this issue I’ve ranked the emerging markets from the latest World Bank – GDP data 2012. It is these largest emerging economies that will have the greatest international impact. Here are the EM’s taken from the top 30. As you might expect, the BRIC’s are at the top: –

Gross domestic product 2012

Economy                        Mlns US dollars
2 China                               8,227,103
7 Brazil                               2,252,664
8 Russian Federation      2,014,775
10 India                              1,841,710
14 Mexico                           1,178,126
15 Korea, Rep.*                 1,129,598
16 Indonesia                      878,043
17 Turkey                            789,257
19 Saudi Arabia                 711,050
22 Iran, Islamic Rep.       514,060
26 Argentina                      475,502
28 South Africa                 384,313
29 Venezuela, RB              381,286
30 Colombia                      369,606

Source: World Bank

*It may be argued that South Korea shouldn’t be included since it has emerged.

The complete list is here:-

Click to access GDP.pdf

BRIC Bats

In the table above, the “Fragile Five” are all represented – although only two of the “Vulnerable Five” – with Thailand (31) just outside. Given their prominence however I want to examine the prospects for the largest EM economies – the BRICs:-

• China is a year into its economic rebalancing away from production and towards domestic consumption. This is a slow process; some commentators anticipate it may take as much as a decade to work through. Whilst GDP growth remains robust – IMF forecast real GDP of 7% plus out to 2018 – it is well below the nearly double digit growth of the last decade. As the world’s second largest economy China will set a benchmark for the rest of the developing world. Official statistical data from the PRC is notoriously unreliable so a true picture of the success or failure of economic reform may be difficult to discern. The level of debt, especially in the public sector, and the demographic effects of the “one child” policies of the Mao era, are likely to subdue economic growth for a considerable time.

The following article from Macrobusiness.com.au looks at Chinese Iron Ore port stocks: –

http://www.macrobusiness.com.au/2014/02/daily-iron-ore-price-update-cliffs-edge/

This indicates a continued slowing of the Chinese economy. Whilst Iron Ore port inventories are a rather narrow indicator of expected demand the recent decline in Rebar prices shows that demand from the construction industry remains muted.

• Brazil has been battling high inflation – 5.59% January 2014, down from 6.7% last summer but still above the central bank target of 4.5%. Growth has been slowing since the 2010 rebound and commodity prices have remained under pressure. An election in September 2014 and the opportunity for public protests around the FIFA World Cup add to the uncertainty.

• India has seen its currency under pressure for some time. Ranjan, the new governor of the Reserve Bank of India, has already raised interest rates three times, to 8%, since his election in September 2013. This only takes rates back to their 2012 level. Meanwhile industrial production is lacklustre and the bursting of the housing bubble continues to act as a drag on the economy. Inflation has been running in double digits for the past couple of years and only dropped to 9.13% in January.

• Russia has slightly less inflation concern (6.1% in January) and central bank rates have been held at 5.5% since September 2013. Commodity prices have remained a drag on growth (1.2% in Q3 2013). The current account surplus continues to diminish despite the relative stability of the oil price. Another issue for Russia is their standing on Transparency International’s Corruption Perceptions Index. Russia ranks 127, the lowest of the BRIC countries.

Full 2013 Transparency International CPI results are here:-

http://cpi.transparency.org/cpi2013/results/

EM institutions must remain calm

Perhaps a greater risk for EM countries may be policy mistakes from there own institutions, as this article from the Peterson Institute – Emerging Market Victimhood Narrative – January 31st – suggests: –

http://www.piie.com/publications/opeds/oped.cfm?ResearchID=2561

From Istanbul to Brasilia to Mumbai comes a crescendo of complaints about dollar imperialism. Heads of state and central bank governors allege that the policies of central banks in industrial countries, especially the US Federal Reserve, pursued in self-interest, are wreaking havoc in emerging-market economies. This allegation is mostly unfair. Emerging markets aren’t hapless and undeserved victims; for the most part they are simply reaping what they sowed.

Interest rate increases by EM central banks to combat higher inflation due to currency depreciation poses a significant “contagion” risk. They should take note of the actions of the BoE, who missed its inflation target every month since November 2009. Now inflation is back to target (December 2013) and the UK economy is predicted to be the strongest in Europe this year, see last weeks post: –

https://inthelongrun.co.uk/2014/01/31/whither-the-uk-from-tantalus-to-sisyphus/

For emerging market officials to blame the Federal Reserve might be populist but it will antagonise international relations. Emerging market central banks and their governments need to concentrate on those internal factors they can influence. International capital outflows can, to some extent, be reversed by raising interest rates precipitously but at what cost to the domestic economy?

Cross-border Capital flows and the “Carry Trade”

Since the Tech Bubble collapse of 2001, and subsequent slashing of interest rates during the mid-2000’s, a significant amount of developed country investment has flowed towards emerging markets. A large reversal occurred in 2009 but since then developed country central banks have cut interest rates aggressively encouraging renewed enthusiasm for EMs. After a steady period in 2012 credit inflows dried up as US bond yields began to rise. Since the second half of 2013 the overall trend has begun to reverse. The fascinating chart below from the World Bank illustrates the critical impact of credit inflows and outflows over the last 22 years: –

EM Private Capital Inflows - source World Bank

Source: World Bank

The recent outflows from emerging markets have benefitted capital account surplus countries; especially the UK – it is a factor underpinning the appreciation of GBP.

These “repatriations”, are likely to continue despite emerging market central banks increasing interest rates to defend their currencies. It is still quite early in the repatriation cycle and expectations are currently dominated by the prospect of further Fed tapering.

EM short term interest rates are rising but as the chart below illustrates 10 yr bond yields have not risen to extreme levels at this stage. The comments are courtesy of Mauldin Economics:-

EM Bond yields - source Mauldin Economics and Bloomberg

Source: Bloomberg and Mauldin Economics

Whilst yields have risen, the situation doesn’t look too dire, especially when compared to EM currencies; chart below again courtesy of Mauldin Economics: –

EM Currencies - source Mauldin Economics and Bloomberg

Source: Bloomberg and Mauldin Economics

The next chart, once more care of Mauldin Economics, shows the relatively stable, although high, inflation rates in some of the larger emerging markets. Several EM central banks have raised interest rates this year and I expect to see investors return to higher yielding bond markets as developed country bond yields fall – a kind of “self-righting” mechanism will see a return of capital inflows. This may take a few months to materialise and, should EM central banks panic, a full-blown crisis could ensue in the meantime. This month the sentiment is fragile, as exemplified last week by both the Russian and Brazilian governments’ cancelling their bond auctions. The point made by Maudlin is the crux of the issue: as developed market rates rise the attraction of the carry trade diminishes. I simply don’t expect developed market bond yields to rise dramatically when disinflationary forces are blowing from the depreciating EM’s.

EM Inflation - source Mauldin Economics and Bloomberg

Source: Bloomberg and Mauldin Economics

In some ways the marginal capital flows which affect currencies, bonds and stocks, are all a form of the classic “Carry Trade”. So what is different about the carry trade since 2008?

As developed world central banks cut interest rates towards the zero bound, so the carry trade, which had traditionally relied upon the JPY (and to a lesser extent the CHF) for funding, became attractive to fund in USD, EUR and even GBP. In the past, interest rate differentials between the major markets had been significant – and therefore attractive to the carry trader. In the new, post 2008 environment, the carry trade destination became more concentrated in less liquid markets such as peripheral European bonds, higher yielding mortgage and corporate bonds and, of course, emerging markets.

This article from Prospect Magazine – Are Emerging Markets a storm in a teacup, or a storm that’s brewing? – 6th February 2014 – picks up on a World Bank report: –

A recent study by the World Bank (Global Economic Prospects, January 2014) estimated that US interest rates, QE and other external factors accounted for 60% of the increase in capital flows to emerging countries between 2009-13, with domestic factors accounting for the remainder.

They go on to point out: –
So next time someone says emerging market currencies are a storm in a tea cup, you can remind them of two things. First, you can point out that slower growth, flawed development models, excessive reliance on credit and foreign capital inflows, and weak institutions constitute a rather different cocktail. Secondly, you can emphasise that raising interest rates to defend your currency doesn’t always work. It might just exacerbate the underlying problem of weak growth, low returns to investment, and political tension, and so spur another bout of capital flight, and so on.

At some point, a buying opportunity for the brave and fleet of foot in emerging markets is as certain as night follows day. But the emerging market growth crisis is still in Act 1 of a rather long play.

http://www.prospectmagazine.co.uk/prospector/are-emerging-markets-a-storm-in-a-teacup-or-a-storm-thats-brewing/#.UvtJBJRFDMw

Another look at the currency and bond charts above suggests that whilst the currencies are leading the way, bonds are still broadly within their recent ranges. Many commentators anticipate higher EM bond yields in the wake of currency weakness, this remains a risk near-term. By contrast, EM equities, as measured by the MSCI EM Index, look range-bound. They failed to follow the major markets higher last year. Looking ahead, trade surplus EM countries will benefit from a weaker currency as it makes their export sector more competitive: –

MSCI Emerging Market ETF - 5 yr - source yahoo finance

Source: Yahoo Finance

Back in November 2013 Anders Aslund wrote, what may turn out to be, a prescient article for the Peterson Institute – Why Growth in Emerging Economies Is Likely to Fall, here are some highlights: –

The high growth rate of the emerging economies has become widely accepted as the new normal.
A new conventional wisdom has arisen, that economic convergence between the developed and the
emerging economies is all but inevitable and that China will soon overtake the United States economically and rule the world. Books such as Eclipse: Living in the Shadow of China’s Economic Dominance (Subramanian 2011) and When China Rules the World (Martin 2012) have become staples. However, the two preceding decades, 1981–99, off er a sharp contrast. Emerging economies grew only at an average of 3.6 percent a year during those decades, while the US economy grew at 3.4 percent a year. Considering that the initial US economic level was so much higher, no economic convergence occurred between the United States and the emerging economies during those two decades.

… The hypothesis of this paper is that the emerging market growth from 2000 to 2012 was atypically high and we might be back in a situation that is more reminiscent of the early 1980s. The growth of the last 12 years was neither sustainable nor likely to last. Several cycles that are much longer than the business cycle exist. One is the credit cycle, which Claudio Borio (2012) assesses at 15 to 20 years.

Another is the commodity cycle, which last peaked in 1980 and might last 30 to 40 years (Jacks 2013, Hendrix and Noland forthcoming). A third is the investment or Simon Kuznets cycle, which appears related to both the credit and commodity cycles (Kuznets 1958). A fourth cycle is the reform cycle, which might also coincide with the Kondratieff cycle (Rostow 1978).

The purpose of this paper is by no means to prove the existence of these cycles and even less to
discuss their length. My argument is much more limited: A large number of emerging economies seem to be close to a turning point in all these four cycles. The credit, commodity, and investment cycles have peaked out, while reforms on the contrary have tended to occur during crises and need to be restarted. It usually takes a decade or two to embark on, design, and implement new reforms. I offer seven arguments why high emerging-economy growth is over:
1. One of the biggest credit booms of all time has peaked out. Extremely low interest rates cannot
continue forever. A normalization is inevitable. Many emerging economies are financially vulnerable with large fiscal deficits, public debts, current account deficits, and somewhat high inflation.
2. A great commodity boom has peaked out, as high prices and low growth depress demand, while the high prices have stimulated a great supply shock.
3. The investment or Simon Kuznets cycle has peaked out, as the very high Chinese investment ratio is bound to fall and real interest rates to rise.
4. Because of many years of high economic growth, the catch-up potential of emerging economies has been reduced and growth rates are set to fall ceteris paribus.
5. Many emerging economies carried out impressive reforms from 1980 to 2000, but much fewer
reforms have taken place from 2000 to 2012. T e remaining governance potential for growth has
been reduced. Characteristically, reforms evolve in cycles that are usually initiated by a serious crisis, and after 12 good years complacency has set in in the emerging economies.
6. Worse, the governments of many emerging economies are drawing the wrong conclusion from
developments during the Great Recession. Many think that state capitalism and industrial policy have proven superior to free markets and private enterprise. Therefore, they feel no need to improve their economic policies but are inclined to aggravate them further.
7. Finally, the emerging economies have benefited greatly from the ever more open markets of the
developed countries, while not fully reciprocating. The West is likely to proceed with selective,
regional trade agreements rather than with general liberalization.

Here is the full article: –

Click to access wp13-10.pdf

Countering this well argued case for an EM slowdown is a fascinating paper from the BIS – Asia’s decoupling: fact, forecast or fiction? December 2013, here’s the abstract:-

Standard measures of real economic co-movement between Asia-Pacific economies and those elsewhere had been observed to follow a downward trend, leading some commentators to suggest that the region was decoupling. However, this process reversed in response to the International Financial Crisis, and co-movement increased to historically high levels for some economies. We examine co-movement patterns and show that these are very sensitive to changes in macroeconomic volatility over time. Controlling for this, however, co-movement is closely linked to underlying trade and financial integration. If international links continue to strengthen in future, co-movement will strengthen in tandem. Decoupling is more a fiction than a fact or a forecast.

Click to access work438.pdf

Developed markets and globalisation
If the world economy is becoming more coupled due to globalisation, then the monetary conditions of the major economies is critical to understanding how the nascent emerging market crisis might play out.

As a broad generalisation, emerging markets rely on Trade Exports and International Capital Investment, so the robustness of their trading and finance partners is a critical but often overlooked aspect of any analysis. I am indebted to Pi Economics for the chart below which tracks broad money growth in US, EU, UK and Japan.

Weighted Average Broad Money Growth - US EU Japan UK - source Pi Economics

Source: Pi Economics

Given that broad money growth of 4 – 5% is consistent with inflation of around 2% – a statement with which many would disagree since it ignores velocity, liquidity preference and a number of other factors – I would suggest that, as long as the Federal Reserve, ECB, BoE, BoJ etc. maintain inflation targets, further accommodative policies are likely to prevail.

For more reading on the link between broad money growth and inflation the ECB – Long Run Evidence on Money Growth and Inflation – WP 1027 – March 2009 may be informative, there’s plenty more from other central banks too.

Click to access ecbwp1027.pdf

With falling money supply growth disinflation is an increased risk. George Selgin – Less than zero –is an excellent introduction to the heterodox idea that falling prices are a good thing. This remains at odds with the inflation targeting mandates of the major central banks. Here is the IEA link:-

Click to access upldbook98pdf.pdf

Many EM countries already have some form of price, capital or currency controls in place. As international inbound capital flows have slackened or reversed many of these controls have been tightened. As those countries which can, weaken their currencies, their export competitiveness will improve. For the developed countries import prices should decline. This will temper domestic inflation, making higher interest rates unnecessary. Any domestic slowdown in economic activity in developed countries will then prompt an increase in QE.

Since the beginning of 2014 US, UK and German bond markets have rallied. Traditionally, lower bond yields, except during times of crises, are positively correlated to higher equity prices. With developed markets exhibiting anaemic growth, a reasonable proportion of this additional liquidity is bound to seek out higher yielding bonds and growth stocks. This will lead to renewed capital flows into EM equities.

Commodity prices remain subdued, see my post from last year: –

https://inthelongrun.co.uk/2013/12/16/commodity-super-cycles-in-a-fiat-currency-world-3/

Many of the largest emerging economies are still slowing. More robust growth in the UK and USA looks like the exception rather than the rule for the developed world and money supply growth in the major economies is disappointingly weak. None of this suggests that the main catalyst of asset price appreciation (QE) will disappear in the next five years. If 60% of the capital flows into emerging markets are the result of QE, and the Federal Reserve are still buying $65bln per month, whilst the BoJ are attempting a similar degree of monetary accommodation, I can’t be bearish on EM equities.
It has been argued that the major central banks are mandated to focus on their domestic economies.

Commentators point to the Latin American crisis of the 1980’s or the Asian crisis of the late 1990’s as examples of how the rest of the world will be left to fend for themselves, however, I believe the impact of globalisation is under estimated. When the effects of globalisation are combined with benign inflationary forces in the developed world, together with central bank inflation targets, disinflation will lead to more QE. This will lead to further asset price inflation. We will finally reach a denouement where the mal-investments associated with these ridiculous policies are laid bare, but not until the credibility of central banks has been undermined.

We may yet have a full-blown emerging market crisis but I think it is less likely due to the increased interconnectedness of the world’s economies. If it does happen it will stem from a loss of confidence in EM institutions. The credit inflows pre-2008 have not returned. Regulatory capital increases have undermined the lending capability of banks around the world. There has been less “hot money” flowing to EM markets since the Great Recession and therefore I believe EM markets will keep their nerve.

Whilst their arguments are somewhat different from my own, the Economist – Don’t Panic – 1st February 2014, ends with a salutary warning and a longer-term expectation: –

If enough investors get nervous, money will flood out, currencies will fall and a gradual tightening could become a sudden rout. But there is no reason for American interest rates to rise fast, and no reason why emerging economies cannot adapt to a world in which rates gradually climb.
http://www.economist.com/news/leaders/21595454-there-no-reason-broad-emerging-market-crisis-nervous-investors-could-yet-cause?

Conclusion

A major emerging market crisis is still a real risk, however, I believe the disinflationary effect of their currency depreciations, on the major developed economies will be pronounced. The developed world central banks will not raise interest rates in this environment. This will provide significant liquidity support to emerging markets – especially to equities and those bond markets where the government debt to GDP ratio is not too high, nor the current account balance in substantial deficit. As always, each emerging market should be analysed on its own merits – some deserve the treatment they are receiving at the hands of “Mr Market” others may be damaged by contagion. In general, however, I don’t expect a rout of the magnitude of 1997 this time around. Emerging market equities are a “hold”. They may break lower, in which case reduce, but don’t exit the market just yet, another round of developed world QE may appear, like a knight in shining armour, sooner than you think.