Outlook 2014: The coming US dollar drought
Until recently, emerging markets were the darlings of investors. Yet the mere hint that the US Federal Reserve would start to taper quantitative easing meant the hot money flowed out of these markets just as quickly as it entered.
Some investors might dismiss these moves as merely the short-term gyrations of financial markets but they hint at a longer-term trend. Indeed, we may be on the cusp of a major change of global macroeconomic dynamics which could have a significant impact on emerging markets.
The Fed’s plans to taper quantitative easing are the first steps in a move towards a reduction in global US-dollar liquidity that would accompany a shrinking US current account deficit. That deficit has already started to shrink as fracking has enabled the US to be less reliant on oil imports. Many forecast that the nation will become energy independent, further reducing oil imports and shrinking the current account deficit further.
One of the impacts of cheaper energy is that it enables the US to bring certain industries, such as the production of chemicals, back on-shore. The way that disposable income is being spent in the US is also changing. “Recent data has showed that the improvement in the US growth has been driven by demand for domestic products,” says Remi Ajewole, diversified growth fund manager at Schroders.
That includes a revival in the US housing sector as well as an increased demand for services like restaurants and cinemas rather than imported goods. And demographics are playing a part: the ageing population spends on healthcare and domestic services rather than imported consumer goods. At the same time, increasing wealth means that Chinese consumers can afford more US goods and increasing interest rates should attract net financial inflows to the US. All of these factors will act cumulatively to reduce the US current account deficit and global US-dollar liquidity.
This reversal of US trade and investment flows will have a significant impact on emerging markets – as was seen earlier this year. But it will not be negative for every emerging economy.
Andrew Seaman, managing partner at Stratton Street Capital, says: “In a period of deleveraging, there will be upward pressure on the currency of those countries which are creditors and downward pressure those which are debtors. The capital will flow away from debtor countries to creditor countries.”
This shift in capital flows can be a benign trend when the US simply eases QE and keeps interest rates on hold. Once the Fed starts to tighten, however, the process of deleveraging will be under greater pressure. “In other words, a reduction in US dollar liquidity will result in severe pressure on the weaker emerging market economies,” says Seaman.
Ajewole concurs that the greatest risk is with those countries that failed to improve their public finances during the good times and have both a current and a capital account deficit, making them very reliant on foreign capital.
Two that could be particularly stressed are India and Turkey. “These countries could face liquidity problems if their foreign funding dries up,” says Ajewole. “While the majority of the emerging market economies are struggling to ensure that their exports remain competitive in a world where growth and demand is scarce, the risks are compounded for India and Turkey which need to attract foreign capital to prevent a liquidity crisis the same time. Their economies can easily become unstable.”
A withdrawal of foreign capital will cause the value of the currency to fall. Policy makers must then decide if they want to raise interest rates to protect their currency and keep their debt attractive.
But as Tapan Datta, head of asset allocation at Aon Hewitt observes, governments can hurt growth by trying to shore up currency valuations with rate hikes. “This can result in a bad spiral – if growth is weak, higher interest rates will hurt these economies even more,” he says.
It is clear that investors should take the time to look beneath the economic bonnet of each country – but not necessarily obsess over current accounts.
“It was a logical move for the markets to sell off India and Turkey, as both of these countries have sizeable current account deficits that are reliant on external investments,” says James Upton, senior portfolio specialist for the emerging markets equity team at Morgan Stanley Investment Management. “However, the collapse in the value of the Indonesia rupiah and Indonesian equities was less rational. While Indonesia does have a current account deficit, most of the imports going into the Indonesia were capital goods that would fuel future growth. In contrast, Indian imports were principally consumer goods. Over the medium term, investors need to dig further down into details of each economy. Just because a particular economic metric looks worrying, that does not necessarily mean the country is vulnerable.”
Nor should investors stop at those metrics, which are likely to be directly impacted by a reduction in the US current account deficit: endogenous factors also needed to be considered.
For example, in recent years there has been an expansion in the use of domestic credit by emerging markets. Datta says: “Domestic financial credentials in the emerging markets have moved onto shakier ground in the last few years.”
Upton says: “In aggregate, over the past four years, it has taken $2 of private sector debt to drive $1 of growth in emerging markets. This is a domestic credit expansion issue for some countries but less of an issue for others.”
China has had the biggest expansion of domestic credit relative to GDP over the last five years compared with all other markets. Brazil, Turkey and Thailand have also had a significant expansion in credit growth.
Upton says: “Our studies show that in all of these countries’ credit growth has exceeded GDP growth by 5% for five years in a row. That’s a red flag, which signals the possibility of an economic slowdown.”
By combining endogenous and exogenous economic factors, investors will be able to get a much more nuanced picture of the relative strength and weaknesses of different emerging market countries. And it will enable them to see which countries will do badly in response to a particular set of stresses.
For example, Turkey has a sizeable current account deficit. The eventual reduction in global liquidity and the country’s over-extended domestic credit are two factors that could create a very unstable environment. “That’s very useful information for investors,” says Upton.
Seaman agrees that it will be vital for investors to start distinguishing between different emerging markets as there will be an stark dichotomy between those that will and will not be robust enough to survive in the new world order.
“In addition to shrinking US dollar liquidity there will be an increase in renminbi currency holdings,” he says. “We forecast it will become the third most traded currency in the world by 2015 and it will be funded by outflows from other emerging market currencies which could put further pressure on these economies. The concentration risk for a global fixed income benchmark is even more acute than it is for equity index, as those countries with the greatest debt make up the greatest proportion of the fund. Given the pressure that debtor countries will come under in the coming years, investors should seriously re-consider using this type of approach.”
The global economy is on the cusp of a change in trade patterns that will result a shift in the size of the major nations’ current account deficits. Under these circumstances, life could become very tough for some emerging economies while others will continue to prosper. Investors will need to employ more sophisticated techniques to cherry-pick the winners from the losers.