Global Investing

Doves to rule the roost in emerging markets

Interest rate meetings are coming up this week in Turkey,  South Africa and Mexico.  Most analysts expect no change to interest rates in any of the three countries.  But chances are, the worsening global growth picture will force policymakers to soften their tone from previous months; indeed forwards markets are actually pricing an 18-20 basis-point interest rate cut in South Africa.

Doves in South Africa will have been encouraged by today’s lower-than-expected inflation print, coming soon after data showing a growth deceleration in the second quarter of the year. Investors have flooded the bond markets, betting on rate cuts in coming months. In Turkey and Mexico, no policy change is priced but a few reckon the former, reliant on a policy of day-to-day tinkering with liquidity, may narrow the interest rate corridor in a nod to slowing growth.

For now, all three banks could be constrained from cutting rates by fear of currency volatility and the potential knock-on effect on inflation. Of South Africa, analysts at TD Securities write:

In this environment, the odds of a rate cut to 5 percent in the near term are not negligible but… easing rates at this point would increase the risk of inflationary pressures intensifying via the exchange rate channel.

But the feeling overall is that if central banks don’t cut rates this month they will do so soon. In fact, policymakers are already behind the curve with monetary easing, says Benoit Anne, head of emerging markets strategy at Societe Generale.  He reckons that with the U.S. Fed dragging its feel on QE3, worsening growth will soon overshadow any concerns for the currencies and inflation. (South Korea stunned investors last week with its first rate cut in three years). Anne says:

10%-plus returns: only on emerging market debt

It’s turning out to be a great year for emerging debt. Returns on sovereign dollar bonds have topped 10 percent already this year on the benchmark EMBI Global index, compiled by JP Morgan.  That’s better than any other fixed income or equity category, whether in emerging or developed markets. Total 2012 returns could be as much as 12 percent, JPM reckons.

Debt denominated in emerging currencies has done less well . Still, the main index for local debt, JPM’s GBI-EM index, has  racked up a very respectable 7.6 percent return year-to-date in dollar terms, rebounding from a fall to near zero at the start of June.  Take a look at the following graphic which shows EMBIG returns on top:

Fund flows to emerging fixed income have been robust. EPFR Global says the sector took in  $16.2 billion year to date.  JPM, which tracks a broader investor set including Japanese investment trusts, estimates the total at $43 billion, not far off its forecast of $50-60 billion for the whole of 2012.

More EM central banks join the easing crew

Taiwan and Philippines have joined the easing crew. Taiwan cut interbank lending rates for the first time in 33 months on Friday while Philippines lowered the rate it pays banks on short-term special deposits. Hardly surprising. Given South Koreas’s shock rate cut on Thursday, its first in over three years, and China’s two rate cuts in quick succession, the spread of monetary easing across Asia looks inevitable. Markets are now betting the Reserve Bank of India will also cut rates in July.

And not just in Asia. Brazil last week cut rates for the eighth straight time  and Russia’s central bank, while holding rates steady,  amended its language to signal it was amenable to changing its policy stance if required.

Worries about a growth collapse are clearly gathering pace. So how much room do central banks have to cut rates? Compared with Europe or the United States, certainly a lot.  And with the exception of Indonesia and Philippines, interest rates in most countries are well above 2009 crisis lows.  But Deutsche Bank analysts, who applied a variation of the Taylor rule (a monetary policy parameter stipulating how much nominal interest rates can be changed relative to inflation or output), conclude that in Asia, only Vietnam and Thailand have much room to cut rates. Malaysia and China have less scope to do so and the others not at all (Their model did not work well for India).

Korea shocks with rate cut but will it work?

Emerging market investors may have got used to policy surprises from Turkey’s central bank but they don’t expect them from South Korea. Such are the times, however, that the normally staid Bank of Korea shocked investors this morning with an interest rate cut,  the first in three years.  Most analysts had expected it to stay on hold. But with the global economic outlook showing no sign of lightening, the BoK probably felt the need to try and stimulate sluggish domestic demand. (To read coverage of today’s rate cut see here).

So how much impact is the cut going to have?  I wrote yesterday about Brazil, where eight successive rate cuts have borne little fruit in terms of stimulating economic recovery. Korea’s outcome could be similar but the reasons are different. The rate cut should help Korea’s indebted household sector. But for an economy heavily reliant on exports,  lower interest rates are no panacea,  more a reassurance that, as other central banks from China to the ECB to Brazil  ease policy, the BoK is not sitting on its hands.

Nomura economist Young-Sun Kwon says:

We do not think that rate cuts will be enough to reverse the downturn in the Korean economy which is largely dependent on exports.

SocGen poll unearths more EM bulls in July

These are not the best of times for emerging markets but some investors don’t seem too perturbed. According to Societe Generale,  almost half the clients it surveys in its monthly snap poll of investors have turned bullish on emerging markets’ near-term prospects. That is a big shift from June, when only 33 percent were optimistic on the sector. And less than a third of folk are bearish for the near-term outlook over the next couple of weeks, a drop of 20 percentage points over the past month.

These findings are perhaps not so surprising, given most risky assets have rallied off the lows of May.  And a bailout of Spain’s banks seems to have averted, at least temporarily, an immediate debt and banking crunch in the euro zone. What is more interesting is that despite a cloudy growth picture in the developing world, especially in the four big BRIC economies,  almost two-thirds of the investors polled declared themselves bullish on emerging markets in the medium-term (the next 3 months) . That rose to almost 70 percent for real money investors. (the poll includes 46 real money accounts and 45 hedge funds from across the world).

See the graphics below (click to enlarge):

Signals are positive on positioning as well with 38.5 percent of investors reckoning they were under-invested in emerging markets, compared to a quarter who felt they were over-invested. Again, real-money investors appeared more keen on emerging markets, with over 40 percent seeing themselves as under-invested. SocGen analysts write:

Sell in May? Yes they did

Just how miserable a month May was for global equity markets is summed up by index provider S&P which notes that every one of the 46 markets included in its world index (BMI)  fell last month, and of these 35 posted double-digit declines. Overall, the index slumped more than 9 percent.

With Greece’s anti-austerity May 6 election result responsible for much of the red ink, it was perhaps fitting that Athens was May’s worst performer, losing almost 30 percent (it’s down 65 percent so far this year).  With euro zone growth steadily deteriorating, even German stocks fell almost 15 percent in May while Portugal, Spain and Italy were the worst performing developed markets  (along with Finland).

The best of the bunch (at least in the developed world) was the United States which fell only 6.5 percent in May and is clinging to 2012 gains of around 5 percent. S&P analyst Howard Silverblatt writes:

India rate cut clamour misses rupee’s fall-JPM

Indian markets are rallying this week as they price in an interest rate cut at the Reserve Bank’s June 18 meeting.  With the country still in shock after last week’s 5.3 percent first quarter GDP growth print, it is easy to understand the clamour for rate cuts. After all, first quarter growth just a year ago was 9.2 percent.

Yet,  there may be little the RBI can do to kickstart growth and investment.  Many would argue the growth slowdown is not caused by tight monetary conditions but is down to supply constraints and macroeconomic risks –the government’s inability to lift a raft of crippling subsidies has swollen the fiscal deficit to almost 6 percent while inhibitions on foreign investment in food processing and retail keep food prices volatile.  

The other side of the problem is of course the rupee which has plunged to record lows amid the global turmoil. Lower interest rates could  leave the currency vulnerable to further losses.

Indian risks eclipsing other BRICs

India’s first-quarter GDP growth report was a shocker this morning at +5.3 percent. Much as Western countries would dream of a print that good, it’s akin to a hard landing for a country only recently aspiring to double-digit expansions and, with little hope of any strong reform impetus from the current government, things might get worse if investment flows dry up. The rupee is at a new record low having fallen 7 percent in May alone against the dollar — bad news for companies with hard currency debt maturing this year (See here). So investors are likely to find themselves paying more and more to hedge exposure to India.

Credit default swaps for the State Bank of India (used as a proxy for the Indian sovereign) are trading at almost 400 basis points. More precisely, investors must pay $388,000  to insure $10 million of exposure for a five-year period, data from Markit shows. That is well above levels for the other countries in the BRIC quartet — Brazil, China and Russia. Check out the following graphic from Markit showing the contrast between Brazil and Indian risk perceptions.

At the end of 2010, investors paid a roughly 50 bps premium over Brazil to insure Indian risk via SBI CDS. That premium is now more than 200 bps.

Quiet CDS creep highlights China risk

As credit default swaps (CDS) for many euro zone sovereigns have zoomed to ever new record highs this year, Chinese CDS too have been quietly creeping higher. Five-year CDS are around 135 bps today, meaning it costs $135,000 a year to insure exposure to $10 million of Chinese risk over a five-year period. According to this graphic from data provider Markit, they are up almost 45 basis points in the past six weeks.  In fact they are double the levels seen a year ago.

That looks modest given some of the numbers in Europe. But worries over China, while not in

 

the same league as for the euro zone, are clearly growing, as many fear that the real scale of indebtedness and bad loans in the economy could be higher than anyone knows.  Above all, investors have been fretting about a possible hard landing for the economy, with the government unable to control  a growth slowdown.

Battered India rupee lacks a warchest

The Indian rupee’s plunge this week to record lows will have surprised no one. After all, the currency has been inching towards this for weeks, propelled by the government’s paralysis on vital reforms and tax wrangles with big foreign investors. These are leading to a drying up of FDI and accelerating the exodus from stock markets. Industrial production and exports have been falling.  High oil prices have added a nasty twist to that cocktail. If the euro zone noise gets louder, a balance of payments crisis may loom. The rupee could fall further to 56 per dollar, most analysts predict.

True, the rupee is not the only emerging currency that is taking a hit. But the Reserve Bank of India looks especially powerless to stem the decline. (See here for an article by my colleagues in Mumbai) .  One reason  the RBI’s hands are  effectively tied is that  India is one of the few emerging economies that has failed to build up its hard currency reserves since the 2008 crisis and so is unable to spend in the currency’s defence. Usable FX reserves stand now around $260 bilion, down from $300 billion just before the 2008 crisis.  See the following graphic from UBS which shows that relative to GDP, India’s reserve loss has been the greatest in emerging markets.

But there is worse. The relative decline in reserves since 2008 coincides with a ballooning in India’s external debt, both private and public. Comprising mostly of corporate borrowing and trade credit, the debt stands at $350  billion, up from $225 billion four years back.