Emerging-markets risk shattering into BIITS

Investors in emerging markets are becoming more discerning about where they put their money, shying away from countries such as Brazil, India, Indonesia, Turkey and South Africa. Behind the discrimination is a newfound focus on current-account deficits and structural weaknesses exposed by the likelihood of less stimulus from the Federal Reserve and cooling demand in China, according to economists from HSBC Holdings, JPMorgan Chase & Co. and International Strategy & Investment Group.
That’s a break from the past four years, when emerging markets mainly moved in tandem, seen as either a blanket buy or sell, with little regard to their individual circumstances. Such a mindset was epitomized by the popularity of the BRIC acronym coined for Brazil, Russia, India and China to reflect their potential as future economic powerhouses.
“Investors will be far more choosy among emerging markets than they’ve been in the past,” said Donald Straszheim, head of China research at ISI. “There will be a natural inclination to seek out the ones that are the best positioned.”
Mexico, the Czech Republic and South Korea are among the still-attractive countries because they are less reliant on foreign finance or took advantage of easy money from Fed stimulus to strengthen their economy.
Surprise decision
The Fed’s surprise decision in September to continue its asset purchases provided emerging markets with a respite, as sales of their currencies abated. The reprieve will be temporary, according to Michael Shaoul, chairman of Marketfield Asset Management, which manages about $17 billion.
Some of these nations will see further capital outflows in the next three to six months as investors start to “break it down between good EMs and bad EMs,” he said. His firm is betting against emerging-markets equities and bonds, including those of Brazil and India.
“I don’t think the bear market in EMs has bottomed,” he said. “There is a real selling opportunity.”
The theme of differentiation is gaining ground as the International Monetary Fund warns that growth in emerging and developing countries is the weakest since 2009. The lender cut its forecast Oct. 8 to show them expanding 4.5% this year, down from a July prediction of 5%.
Since the start of May — the month the Fed signaled that it may consider paring its $85 billion in monthly bond purchases — the Indonesian rupiah has fallen 11% against the dollar, and the Indian rupee has declined 12%, with the Turkish lira dropping 9% and Brazilian real losing 8%. By contrast, the Mexican peso has lost 5%, the South Korean won has risen 3.8% and the Czech koruna has climbed 3.5%.
The worst may not be over for the BIITS, if the past is any guide. The Brazilian real lost 51% in 2001-02, the Indonesian rupiah plunged 86% in 1997-98 and India’s rupee fell 42% during 1990-92. In 2000-01, the Turkish lira declined 68% and the South African rand depreciated 52%.
Many emerging markets also used up a lot of their defenses fighting the global financial crisis in 2008, said Mohamed El-Erian, chief executive and co-chief investment officer at Pacific Investment Management Co., the manager of the world’s biggest bond fund.
Old habits
While Mexico is “doing the right thing,” he said, Brazil is “back to its old habits” and Turkey “denies it has a problem.”
As these differences become more apparent, people now want “to buy the best-of-breed,” said Marc Chandler chief currency strategist at Brown Brothers Harriman & Co., which has about $3.4 trillion in assets under custody and administration.
“The Mexico story is attractive and more compelling than some of the others in the region,” while “the BIITS list might be the more troubled emerging markets.”
At the same time, developing-economy stocks and currencies may have been oversold, and many will be able to recover as investors reacquire a taste for risk, according to Jeff Chowdhry, head of emerging-markets equities at F&C Asset Management, which oversees about $150 billion.
“The terrible five could do pretty well because they’ll have improvements in the currencies and stock markets,” he said. “From our perspective, we’re finding the most opportunities in those economies, with the exception of South Africa.”
Investors are taking a closer look as The Institute of International Finance Inc. predicts that private-capital flows into emerging markets will fall $153 billion to $1.1 trillion in 2013 and slide another $33 billion next year.
“The basic story for EM right now is, we’re going through an adjustment,” Bruce Kasman, chief economist at JPMorgan Chase, said in an Oct. 11 panel discussion at the IIF. “There were excesses that were created. It’s going to take a while to work this out, and I don’t think we should expect EM to come back to anything like we were used to.”
Behind the palpitations are slower growth in China, compared with the mid-2000s, and signs that U.S. monetary policy may be reaching a turning point, according to Stephen King, chief economist at HSBC Holdings.
Low-rate environment
Previously, China’s double-digit expansion prompted investors to bet that it would serve as a magnet for the products and commodities of other emerging markets, he said. In addition, a low-interest-rate environment in developed countries led capital to seek higher returns elsewhere, masking or even encouraging fault lines such as widening current-account deficits, weak productivity, a small share of investment relative to domestic consumption, and delays in infrastructure improvements.
“After the financial crisis, the magic asset was mostly to be found in emerging markets, and money poured in,” Mr. King said during the Oct. 11 IIF panel discussion. It was “often with no regard to whether the underlying quality of growth in the emerging-market world was necessarily particularly good.”
A “return to reality” now is setting in, said Erik Nielsen, global chief economist at UniCredit SpA. The key concern with the BIITS is related to their “reliance on short-term foreign financing, particularly as global trade grows very slowly, and we are moving towards some sort of monetary normalization.”
Brazil has suffered a slump in the real after relying on credit-led consumption, which failed to boost productivity and returned the country’s current account to a deficit of about 3% of gross domestic product.
Indonesia is hampered by inflation close to a four-year high and a record current-account shortfall. India is held back by cooling growth, elevated inflation, inadequate roads and other infrastructure, and distorted regulations. Standard & Poor’s in September reiterated that it may downgrade the country’s credit rating to junk on risks such as budget and current-account imbalances.
Turkey and South Africa now have current-account gaps bigger than 6% of GDP. Russia is hobbled by weaker global demand for its exports of oil, natural gas and metals, and is growing at the slowest pace since a 2009 contraction.

(Bloomberg News)