The pressure continues

by Maarten-Jan Bakkum, Senior Strategist, Emerging Markets, NN Investment Partners

It has been a while since the Argentine peso collapsed and the IMF (International Monetary Fund) saved Brazil from a debt crisis with a support package. This all happened in 2002, the last phase of the crisis that began five years earlier in Asia. The similarities with the current emerging market crisis are obvious – rapidly declining growth, sharply depreciating currencies, rising political risk, and Brazil is in the eye of the storm again – but the differences are equally obvious. In the years 1997-2002, numerous countries had balance of payments issues and banks imploded. The IMF had to intervene regularly to prevent worse. The current growth problems seem at least as great, but there are no system shocks yet. Despite substantial market pressure and high credit growth in previous years, large defaults have so far failed to materialise. Is this a sign of resilience or has the pressure simply not been high enough?

This question is crucial, especially in the current market environment, because after an average depreciation of 40 percent against the dollar over the last four years, emerging currencies have already priced in a lot of problems. The same can be said of equity markets: in five years, emerging market equities have underperformed developed market equities by as much as 60 percentage points.

At the end of the summer, almost all professional investors were positioned for more misery in emerging markets, especially since the mini-devaluation of the renminbi had created new concerns about China. But in the same period, the average growth momentum in the emerging world began to recover a little, after eight consecutive months of deterioration. And in September, the Fed decided not to raise interest rates. These factors gave rise to a significant recovery in emerging markets in recent weeks; a recovery of equities, currencies and bonds.

The recent price increases can thus be explained. But is this a temporary rebound or the beginning of a more structural recovery? To answer this question, we must first explain why the current crisis has caused no major calamities. For if the conclusion would be that the emerging world this time is strong enough to prevent major defaults or banking crises, we could be at the beginning of a nice market recovery. In that case, the correction in currencies and interest rates of recent years has probably been sufficient to restore the worst imbalances.

But there are three good reasons to believe that it is only a matter of time before major problems will arise in the financial systems of the fundamentally weakest emerging markets: the slowdown of Chinese growth that makes a lasting recovery in commodity prices and global trade growth unlikely, the normalisation of US monetary policy that will keep the pressure on capital flows to emerging markets, and most importantly, the excessive credit growth, especially after 2008, in at least half of the emerging world. In the current market recovery, these problems receive less attention. But that does not mean that they are gone.