There are fears that the inevitable slowdown in the US economy could prove contagious for the world’s more volatile markets, despite the general optimism. Kevin Hall reports
While the IMF congratulated itself, at its meeting in New York in September, on the recovery in emerging markets following last Autumn’s crisis, fund managers continued to grapple with volatile markets around the world.
Although there is general optimism, as our regional breakdown indicates, fund managers still have one or two worries as the millennium approaches. These include the strength of the global economic recovery, the progress on fiscal and corporate governance in emerging markets, commodity prices, the direction of long-term US interest rates, inflation fears and the small matter of Y2K readiness.
In its twice-yearly check on the global economy, the fund’s World Economic Outlook warned that, although the US economy had moderated global slowdown, a corresponding slowdown in North America was not only desirable but inevitable. The question then becomes: is this a hard landing, and can Japan and Europe take up the slack? This is a particularly important
question for the markets of eastern Europe and Asia. Inevitably, Latin America will be vulnerable, as will some Mediterranean markets.
Roni Argi, Mediterranean Equity Analyst at HSBC in London, says: “All eyes are on the US. The worst-case scenario is if a
sudden correction comes; and this could be triggered by an interest rate increase. The result would be a slowdown in the US economy and many emerging markets depend on that, most significantly cases such as Mexico and Israel which have a special relationship with the US economy. That would spark worries about contagion from the US economy to emerging markets.”
Anand Aithal, Senior Portfolio Analyst with Goldman Sachs in Singapore, believes we are unlikely to see the hard landing in the US which many emerging-market investors fear. “We believe it is far more likely that we will see a soft landing in North America, impacting gently on emerging markets. Consequently, we are predicting interest rate hikes next year of as little as 50 to 75 basis points. This is negligible in terms of external impact,” he says.
Although there are some fears about the strength of the Japanese recovery, especially in light of the performance of the Yen, the WEO revised growth figures, for this year and next, sharply upwards, from -1.5% to 1% in 1999 and 0.3 to 1.5% in 2000. Concern was expressed, nonetheless, about domestic confidence both in the household with falling incomes and job losses, and in businesses less exposed to international competition and structural reform demands. These businesses are still suffering from large debt burdens and excess capacity.
Nevertheless, most analysts are confident that Japan can help to drive the recovery in Asia, especially as the region tends to be self-feeding.
WEO is more optimistic about Europe, with growth in the Euro-zone projected to rise by 2% in 1999 and 2.8% next year. Downside risks have been reduced following the fall in interest rates both within and outside of Euroland, and there are signs that the pick-up is broadening out from its Franco-German base.
Peter Szopo, managing director of East Fund Management in Vienna, says: “Last year was disappointing in eastern Europe, but recently things have been getting better. The fallow years could be over as increasing fundamentals across Europe help to drive exports. We are seeing
structural reform, as countries, and not only the three fast track candidates, gear up for applications for EU membership.”
Across emerging markets, calls continue for greater transparency and fiscal and corporate reforms, aimed mainly at breaking the links between government and the markets. These can only take place with the support of government and growth in the economy. With elections taking place almost continually across the world of emerging markets, this is not always easy. But there remain reasons to be optimistic given the outlook for many of the economies.
“Growth will provide scope for the vital fiscal reforms taking place across all emerging markets,” says Aithal. “This, in turn, will make them more attractive to investors
and place countries which have achieved their reform targets in a more positive
But as Jane Heap, at Deutsche Bank in New York, points out: “There are problems in Asia despite evidence of western-style, developed institutions.”
Most analysts argue that the countries which have reforms in place, or are clearly committed to changes, are most likely to survive any blips and retain investor confidence. Some argue that the development of liquidity must be the aim of all emerging markets. The theory being that a liquid market must be an orderly one, hence rules and institutions must be developed to guarantee orderliness. Unfortunately, the logic of this leads us to believe that efficient markets are not liquid and liquid markets are not efficient. As Heap points out, there is plenty of cash in the smaller south Asia markets.
Nonetheless, it is clear that some markets, such as Taiwan and Singapore, avoided the full heat of the Asian meltdown thanks to their developmental states, and the fact that they have been able to withdraw equities as a focus for speculation. The trick for emerging economies is to combine long-term capital commitments and patience, and somehow deal with the short-term portfolio flows induced by capital-market liberalisation advocated by the IMF. This is the task facing countries such as Argentina at the moment.
Equally pressing for Argentina, as well as most emerging economies, is the question of commodity prices. Range-bound for the first eight months of emerging market recovery, they are picking up selectively. Although Valentin Carril, at Banco Santander in Santiago, believes that movement of commodity prices is fundamental to the Latin America region, Viksa Nath, global strategist at Credit Suisse First Boston suggests that the historically strong correlation between commodity prices and emerging markets appears to have broken. “In our view restructuring-led recovery rather than price recovery has been driving emerging equities. In other words, economies adjusting fastest to the low pricing power environment led the equity market recovery. Nonetheless, as commodity prices recover, the restructured economies should also continue to recover.”
And the outlook for commodity prices remains optimistic. September’s NAPM figures in the US prompted the report’s survey committee chair, Norbert Ore, to point to a “continued strengthening in prices with pricing power apparent in a broad range of commodities.”
However, Nath points to the divergence between soft and hard commodities. “While metals have been driven upwards by improving industrial production outlook, and oil by effective supply measures from Opec, soft commodity prices are touching new lows. There are two reasons for this: firstly, most of the food producers in the developed world have stronger currencies, and second, because La Nina did not cause the expected drought and shortfall in
Which brings us to perhaps the most potent indicator of emerging market prospects, long-term US bonds. Robin Geffen, portfolio manager at Orbitex Russia and East European Fund, believes short rates do not matter. “The 30-year bond is the benchmark. These long rates will indicate sentiment to emerging markets. If short rates rise, then we have seen the peak of long term rates for nine months,” he says.
Nath takes matters further, saying: “Analysis of American and global trends suggest that the term structure of yield curves is important to discern trends , at least for cyclical emerging markets. The short end of the yield curve, two to 10 years, reflects the cyclical outlook, and emerging markets are correlated with its slope. However, the long end of the yield curve, 10 to 30 years, reflects the structural outlook for economies. If this end-of-the-yield curve steepens, the message to emerging markets investors is negative. Our research suggests that the short end of the yield curve could steepen further in the short term.”
Recent Fed action, and the possibility of further tightening in the US, leads him to argue that there is a medium-term risk of the curve flattening, especially if US economic data remains strong. “This does not spell doomsday for emerging equities, however, since the global-yield curve, bolstered by rising expectations in Europe and Japan, should help them,” he says.
Meanwhile, across emerging markets, inflation has been tackled with a gusto previously reserved for western zealots. There remain pockets of resistance to the overall good news, despite arm twisting from the IMF. In Latin America, Chile and Brazil are facing problems, but like other countries such as Israel, they are sticking to the task. However, investors should note the comments of the Israeli central bank issued at the end of September, when it warned that, unless the government could rein in the fiscal deficit, the only way for interest rates to go was upwards.
“Inflation is unlikely to be an issue in Asia, as there is so much excess capacity,” says Aithal.
Two final issues are taxing analysts as the end of the year approaches. Firstly, the readiness of the markets for the Y2K problem. Whole forests have been chopped down to provide the pulp for the reports on this particular problem in the past year. Most comprehensive reports have focused on infrastructures and sectors.
The bad news is that emerging markets worldwide are facing difficulties. Analysis suggests that transportation, utilities and telecom sectors have amongst the lowest Y2K compliance ratings globally. This is especially worrying as they are critical sectors of any economy. The good news, however, is that generally the banking and financial sectors have the highest rating globally. There remains, however, concern in all regions.
Finally, the reforms being pursued across emerging economies are creating the problem of excess paper on the markets. This is inevitable as reforms progress and many governments divest themselves of stock in state companies. This is the down side of reform, particularly for small markets, as investors use them to raise cash for such flotations. Companies are also taking the opportunity to raise capital prior Y2K.
This puts additional pressure on markets, especially when volumes are low.
China is a major source of these issues, and although some have been put on hold, they are delayed not cancelled. If China’s entry to WTO goes ahead, then north Asia could become the focus of structural change, putting even greater pressure on the smaller markets of south Asia, possibly prompting investors to seriously reduce their exposure in those markets.
Overall, the prospects for next year look promising then, but the best near-term momentum in emerging markets does not always translate into the best longer-term fundamentals. Furthermore, world growth, and more importantly its location, is crucial to investors. With relatively modest upside prospects for US and western European stock markets, we should see a pronounced flow of funds into emerging markets.
The balance of global growth is likely to move away from the US in 2000, and this could have serious consequences for Latin America. With the exception of Mexico, investors are likely to look long and hard at their exposure in the other countries. This may well mean a rotation of cash from the region to emerging Europe, where the EU fast-track countries are geared to respond to potential growth. Poland and Hungary the best positioned to take advantage.
Overall investment themes from analysts continue to favour cyclical markets, although there is strong evidence of secular growth in Asia. This region also exhibits benign inflation. If evidence of a secular fall in long-term inflation continues, moreover, long-term interest rates should fall, helping to support current valuations, even if some traditional measures, such as P/E appear expensive by traditional standards.
Meanwhile, the Middle East and Mediterranean continues to be a defensive region, with interest rates a worry in Israel. In contrast, Turkey is likely to benefit from an IMF package, and fund managers will be watching closely to decide whether this justifies an upgrade to an overweight view.
A slowdown in exposure is inevitable in emerging markets as the year-end approaches. This is due to Y2K worries within the markets themselves, but also because of the possibility of a one-off Y2K inventory accumulation giving a boost to global industrial output. This could put emerging markets under pressure in the New Year as de-stocking commences.
Investors will be dealing in a volatile environment, however good the prospects look.