Emerging Markets: What has Changed

(from my colleagues Dr. Win Thin and Ilan Solot)

What has changed? In short, pretty much everything. The FOMC meeting and the market reaction has fed into a deeper re-pricing of assets globally.

1. The selloff in the EM space has been generalized and across all asset classes.

2. The liquidity squeeze in China intensifies.

3. Turbulence in the streets and in the markets forces Turkey and Brazil to step up their game.

4. Reserve Bank of India and others were also forced to intervene in the FX markets to help support their currencies.

1. The selloff in the EM space has been generalized and across all asset classes. In the FX space, MXN and BRL are the worst hit, falling over 3.0% each since Tuesday. Note, however, that this is roughly the same magnitude of the losses seen in AUD, NZD, and NOK. PEN and TWD have outperformed, but that is little comfort to EM investors. The bloodshed in EM (ex-China) fixed income markets was strongest in South Africa and Turkey, with swap rates up some 60 bps. In the equity space, Brazil and Turkey are leading the way lower.

2. The liquidity squeeze in China intensifies. There are several factors at work, some of which are market-based. For example, there are reports that a large amount of wealth management products sold by the banks are coming due at the end of June. There also has been a decline of capital inflows into China. But mostly importantly, the PBOC continues to play hardball with local banks, driving the 7-day repo rate to as high as 25%. The point they are trying to make is that they want banks to scale bank on the credit expansion plans and manage their own liquidity better. How far the PBOC pushes it remains to be seen, but it is clear that the days of easy money are behind us in China. Markets need to brace for slower growth than what is currently being anticipated (7.7% in both 2013 and 2014). Taken in conjunction with the Fed tapering story, the backdrop for EM has deteriorated considerably.

3. Turbulence in the streets and in the markets forces Turkey and Brazil to step up their game. The Turkish central bank continues to keep liquidity tight in an effort to support the lira after it reaches an all time low. The bank has also resorted to direct intervention via dollar sales. It’s a similar story in Brazil. FX swap interventions have escalated in amounts and in occurrences, and central bank president Tombini is showing a commitment to continue hiking rates. Markets have now almost fully priced in a 75 bp hike at the next COPOM meeting July 9/10. In addition, the Treasury has announced it will buy back some bonds in an attempt to calm panicky local fixed income markets.

4. Reserve Bank of India and others were also forced to intervene in the FX markets to help support their currencies. We believe many others will also begin intervening, not to reverse the direction but rather to keep one-way FX markets from getting too illiquid. Mexico should not have eliminated its circuit-breaker USD auction plan, as it would have been a good mechanism to have in place now. Intervention may also be necessary to stabilize the fixed income markets.