Sell-offs ‘serve as a reminder of EM risk’

Recent emerging market sell-offs were reminders of the risk associated with these countries but they also show the benefits of selective investing, HSBC Gam’s Hervé Lievore has claimed.

The senior macro and investment strategist said poor emerging market performance in 2013 and early 2014 continued a recent trend which has seen emerging market equities lose 2.3 per cent in dollar terms last year, while developed equities gained 27.4 per cent.

This near-30 percentage point gap has not been seen since the emerging market crisis of 1997-98.

“Since 2008, emerging market countries have seen a significant deterioration in their combined current account balance. As a group, excluding China, their combined current account has been in deficit since 2010, after 11 years of surpluses.”

He said the two key reasons for the current account decline were weak global demand in the wake of the credit crunch and diminishing price competitiveness during the past decade as emerging market currencies have strengthened.

Between 2010 and 2012, the combined emerging market current account deficit was entirely covered by foreign direct investment net inflows but the situation deteriorated at the end of 2012. At the same time, Mr Lievore said international lending was constrained by the de-risking of European balance sheets, meaning these markets had no alternative but to rely on often unstable and sentiment-driven portfolio investment inflows.

“The Federal Reserve’s primary goal [with quantitative easing] was to ensure abundant and cheap financial resources to support the US economy,” he added.

“But it came at the expense of risk premiums not only in the US but also in emerging markets and the sell-off of 2013 reflected a broad-based re-pricing of risk.”

The gap between US and emerging market volatility typically stands at roughly nine to 13 percentage points but in the fourth quarter of 2012, it narrowed sharply to a 5-6 percentage point range as emerging market volatility fell and US levels remained relatively stable.

Mr Lievore said the gap remained at this low level before widening back to the previous range in the second quarter of 2013, when the market became aware of upcoming quantitative easing tapering.

“Although convenient to lump emerging markets together, this can be misleading given they are a very diverse set of countries,” he added.

“We saw in 2013 that countries running current account deficits showed greater volatility, a logical consequence of the fact they are net capital importers.

“Conversely, countries like South Korea and Taiwan, which have a net financing capacity, were significantly more resilient.”

For Mr Lievore, this means rebalancing economies should be a priority for emerging market policymakers and this goal should be achievable through reduced domestic demand and/or weaker exchange rates.

“The fact central banks in countries under market pressures took bold measures to stabilise their currencies, at the expense of economic activity, is encouraging in the sense it shows a heightened level of accountability,” he added.