Capital glut has become capital flight in emerging markets. Stock markets in developed economies may be the beneficiaries for now. But the switch merely exchanges one set of risks for another.
Over the past six months, expectations that the U.S. Federal Reserve might taper quantitative easing have hit emerging-market assets across the board. Equities (measured by the MSCI indices) and dollar-denominated bonds, the Russian rouble and Indian rupee are down by 8 percent. Brazil’s real has fallen by 10 percent. Procrastination over Fed tapering could give emerging markets a respite. But the broad trend of weakness seems set to assert itself.
The assumption that emerging economies grow faster is being tested. The International Monetary Fund has axed its 2013 growth predictions for Russia, Brazil, Mexico and South Africa by half a percentage point or more, to below 3 percent for each. Chinese growth forecasts have been cut modestly as exports struggle and credit is tightened.
Political strains are growing. Unrest in Brazil and Turkey is the most serious in years. How governments react is uncertain. Turkey’s central bank is trying to avoid higher interest rates, but burning reserves to bolster the lira may not buy stability. As growth slows and financing gets harder, hidden profligacy and poor governance in emerging markets could be exposed.
The snag is that developed markets aren’t a safe refuge. There is a moderate recovery in the United States. But the euro zone, forecast to contract for the second year running, is a drag. The IMF has halved its growth forecast for Germany to just 0.3 percent this year. The earnings outlook is fuzzy. Yet the EuroStoxx 50 index is up 20 percent in the past year and trades on a trailing price-to-earnings ratio of 16 – hardly cheap. Japan’s growth has shot up thanks to egregious fiscal and monetary easing but growth projections for 2014 have been cut to just 1.2 percent. U.S. markets look the best bet. Still, the S&P 500 is on a p-e of 18, a premium to its historic average. Rising bond yields and financing costs are a threat.
The QE-inspired trend of recent years has been to drive assets to extremes before dumping them. Developed-market investors might well fear the same trap awaits them.