The pattern of overreaction in EMs
Jan Dehn, head of Research at Ashmore, discusses how the markets ganged up on both Brazil and China this year, but at this time next year the focus will have shifted elsewhere, because neither Brazil nor China face anywhere near lethal problems.
We are far more concerned about how on earth the QE economies are going to get out of the financial bubble they are being sucked into. The stock market reaction to very weak data in the US last week is a case in point. How can a market that only rallies on bad news ever create conditions that facilitate a healthy exit from unconventional monetary policies? We also discuss the Ukraine terms of debt restructuring which contain some innovative features.
Every single year a small number of Emerging Markets (EM) countries out of a now sizeable collection comprising more than 60 readily investable countries get into some kind of serious trouble, usually self-inflicted, though sometimes they just experience severe external shocks. Inevitably, their predicaments taint the entire asset class, although usually only for a relatively short period of time. The afflicted countries usually take remedial action and the problems are resolved.
Consider the line-up of troubled EM countries over the past couple of years. In 2013, the financial world and its media hangers-on got into a real tiff about India’s alleged ‘Fragile Five’ structural malaise. South Africa and Indonesia were similarly labelled as lost causes. By early 2014, it was clear that these countries were not quite lost causes after all and the focus shifted to Turkey before shifting to Russia later that year.
This year Brazil and China have been the lightning rods of the EM bears. Each of these episodes follows a remarkably consistent pattern; at first the markets really struggle to make a call on the final outcome, resulting in aggressive selling. Market prices inevitably overshoot to the downside. Meanwhile, the actual crisis turns out to be far less extreme than implied by the worst predictions at the time of the crisis.
This pattern of over-reaction in response to often manageable cyclical or political challenges is so regular that it can comfortably be predicted that both Brazil and China will survive their current challenges and that the world will soon move on to focus on a new set of ‘vulnerable’ EM credits.
Brazil’s problems old news
Brazilian assets had already been the subject of widespread selling long before the recent S&P downgrade of the sovereign debt from investment grade (IG) to junk. For most investors Brazil’s problems have been known and understood for some time. In our view, they are 100% self-inflicted – the result of severe economic mismanagement on the part of the government. The good news is that the damage never got so severe as not to be reversible.
Indeed, the damage is already slowly being reversed through tighter fiscal and monetary policies, though a complete cure is still some time off, because the government’s acute loss of political capital has made it difficult to pass effective corrective measures in parliament.
In fact, there are still easily identifiable downside risks on the horizon, including more economic weakness, further ratings downgrades and possible impeachment of the president and other members of the broader political establishment on account of a wide-ranging scandal over funding of political parties.
Brazil’s growth rate is still declining – witness weak Industrial Production and consumer and business confidence prints last week – however, there are important silver-linings. Fortunately, the problem is ultimately a cyclical one, not a structural one. Parts of Brazil’s economy are showing signs of healing. The erosion in the public finances is already slowing. For example, August’s fiscal outturn was better than expected (the primary deficit narrowed by 0.1% of GDP to a still weak -0.8% of GDP).
The external balances are improving sharply – for example the September trade surplus rose to USD 2.9bn versus USD 2.5bn expected. Petrobras was allowed to raise gasoline prices last week, helping the company’s balance sheet. In our view, Brazil will not default, it will not have a balance of payments crisis and it will not even need the help of outside institutions such as the IMF or the World Bank. Debt levels remain sustainable and FX reserves are adequate. The solutions are known, the new economic team is competent and Brazil’s institutions will continue to function. Brazil will re-emerge from its current troubles, so investors should ultimately view the current weakness as an opportunity. They may need to be patient to harvest returns, but they will come.