Emerging market investors seen facing further shakeout

Investors in emerging market (EM) assets may have to brace themselves for further shakeout in the aftermath of the US Federal Reserve’s signal to end a regime of easy money, American global banking giant Citigroup said.

“The punishment in EM assets has been large and, what is worse, it may not be over,” Citigroup said in a research dated June 21 titled: “Emerging Markets Macro and Strategy Outlook: A Fed Storm.”

The research said the “basic story”  now was that the monetary policy environment in most emerging markets remained benign, while longer-term EM yields would continue to suffer the consequences of a US treasuries re-pricing.

The Citi research doubted expectations  that EM asset prices would stabilize in the near term. Some analysts theorize that a recovery in the US may benefit the segment and that central banks may act aggressively to stabilize their exchange rates by tightening monetary policy.

“Stronger growth in the G10  (group of the world’s most industrialized nations) ought to be good news for EM, but we think G10’s  (group of the world’s most industrialized nations) recovery might be less ‘EM-friendly’ than what used to be the case, since there seems to be some evidence of import-substitution in the US and Japan,” according to the research paper.

Import substitution refers to a strategy of encouraging local production of agricultural or industrial products that would otherwise have to be imported.

Citi is likewise skeptical that tightening monetary policy and endlessly selling foreign exchange reserves could be stabilizing factors for EMs. It noted that in a number of countries where the market implemented rate cuts a month ago—South Africa, Turkey, Colombia, Mexico, Israel—rate increases are now expected.

“We think that for the most part, EM central banks will be very reluctant to raise rates in this low-growth environment,” it said.

At the same time, Citi pointed out three key risks facing developing nations—the economic slowdown in China, the continuing repricing of US treasuries and the deterioration in EM balance sheets.

On the risks concerning China, the research noted that in the short run, the risk was associated with tightening liquidity resulting from the collapsing balance of payments (BoP) surplus. “A longer-term issue lurks as well, which is simply the failure of the economy to respond to the heavy stimulus it has received,” it said.

On the second threat concerning the continuing repricing of US treasuries, Citi said commercial banks had become much less important in generating capital flows to EM, while institutional investors had become much more important. “That means capital flows to EM are less sensitive to short-term US real rates than they used to be, and more sensitive to the long end of the US curve,” it said.

The third threat is seen coming from the deterioration in EM balance sheets resulting from the disappearance of the EM current account surplus and the increasing reliance on domestic spending as a driver of EM growth, supported especially by higher public spending. “This should become an even bigger theme as EM policymakers pursue higher levels of spending on infrastructure,” the research said, adding that EM balance sheets might further deteriorate.

Citi said there were two ways to interpret the recent shakedown on EM assets: the asset class had an exuberantly optimistic assessment before, or the “new” fundamentals are deteriorating so much now that they justify a sizable repricing now.