By Jesse Colombo
Up until a few months ago, emerging markets were widely heralded as the next great “growth engine” that would drive the global economy forward as the ailing economies of the U.S., Europe and Japan took a back seat in the wake of the global financial crisis. Unfortunately, the events of recent months have sent emerging market assets reeling and capital pouring out even faster than it flowed in.
When the most acute phase of the global financial crisis came to an end in mid-2009, record-low interest rates in the U.S., Europe and Japan encouraged investors to move their funds into higher-yielding emerging market assets. In the past four years, $4 trillion worth of capital has flowed into emerging markets, helping to inflate bubbles in bonds, property and, to a lesser extent, equities. Then, in late 2012, two of the world’s most powerful central banks launched aggressive monetary stimulus programs that helped to fuel a parabolic rally in non-BRIC emerging market stocks – the U.S. Federal Reserve’s $85 billion per month QE3 and the Bank of Japan’s deflation-fighting "Abenomics" program.
The emerging markets bubble abruptly hit a brick wall in May of this year as a confluence of bearish catalysts reared their ugly heads around the same time, spooking investors into jettisoning their emerging market holdings en masse.
The first EM sell-off catalyst, which arose in March and April, was rising expectations of a tapering or slowing of the Fed’s QE3 program by late-2013. QE3 was a major reason for the parabolic rally in EM assets, and the prospect of its removal is akin to "taking away the punchbowl as the party gets going." While emerging markets didn’t immediately decline due to taper speculation, commodities were hit hard, which threatened commodities exporting emerging nations.
Secondly, in mid-May, markets began to doubt the efficacy of the BoJ’s Abenomics program, sending the Nikkei down by over 20% in less than a month while causing the yen to rally, which punished carry traders who borrowed cheaply in yen to invest in high-yielding EM assets. By the end of May, violent Turkish protests and the rapidly-declining South African rand pushed emerging market assets over the edge, sending them into a tailspin for the rest of June. Adding insult to injury, global markets panicked as China experienced a sharp credit crunch in mid-June after their central bank cracked down on the nation’s shadow banking system, sending the 7-day repo rate to a record 12% and the overnight repo rate to 25%.
Rising taper expectations and fund outflows have pushed global bonds into a bear market, popping what many people (including myself) consider to have been a global bond bubble, causing U.S. 30-year bonds yields to rise from 2.8% to nearly 4%, and 10-year note yields to rise from 1.6% to nearly 3% in the past four months. Climbing U.S. bond yields have caused emerging market bond yields to surge in lock-step, slamming EM bonds down by an average of 12.8% as investors removed over $20 billion of their capital, as the chart below shows:
The chart of Barclay’s emerging markets bond ETF shows how drastic the EM bond plunge has been:
Early 2013's best-performing emerging stock markets have fallen very sharply, with Turkish stocks plunging by 30%, Indonesian stocks by 25%, Thai stocks by 20%, and Philippine stocks by 20% since the start of the rout, as over $20 billion of capital has been pulled from EM stocks:
A recipe for inflation
The torrent of liquidity flowing out of emerging markets has caused sharp declines in those countries’ currencies, the worst being the Indian rupee’s 22% plunge against the U.S. dollar that brought it to all-time lows. In addition, the Turkish lira has seen a 21% decline, the Brazilian real is down 16%, and the Indonesian rupiah is down 13%. The common denominator among the EM countries with the hardest-hit currencies is that they each run current account deficits in the range of 2-7% of their GDP.
Rapidly depreciating EM currencies are causing their import prices to rise, leading to inflation. Unsurprisingly, India’s once fast-growing middle class is now bearing the brunt of out-of-control inflation. Goldman Sachs (GS) recently downgraded its forecast for EM currencies in expectation of further declines, rising inflation and deteriorating current account balances, in addition to cutting India’s GDP growth forecast to 4% from 6% – a far cry from the 8% growth that was common in the past decade. India’s currency crisis is even drawing comparisons to their balance of payments crisis in 1991.
Other emerging market economies are slowing down dramatically as well. In an effort to shore up their sliding currencies, emerging market central banks are raising interest rates, which I believe will be the catalyst that eventually pops the numerous EM credit and property bubbles when combined with rising bond yields.
The incredible amount of mainstream attention that the emerging markets bubble is now receiving is in stark contrast to the time up until a few months ago when emerging markets were seen as an antidote to many of the woes caused by the global financial crisis – not the cause of the next one. Even Paul Krugman has conceded (after the crash) that "the flood of money into emerging markets now looks in retrospect like another bubble," which is a vindication for vocal EM bubble skeptics like myself. At the same time, it wouldn’t be surprising to see a temporary rebound or “relief rally” for a time in emerging market asset prices after such sharp declines. Unfortunately, I believe that the emerging markets crisis will ultimately get worse when their numerous property bubbles truly deflate.
Jesse Colombo is an economic analyst who is warning about post-2009 economic bubbles, and was recognized by the London Times for predicting the global financial crisis. Jesse can be followed via his Twitter blog.