BNE: Storm clouds overhead, not over emerging markets
“Storm clouds gather over emerging markets”, boomed The Financial Times’ influential leader column in mid-January. This inclement headline was whipped up after the paper choose to focus on a “disorderly adjustment scenario” outlined across just a few paragraphs of the latest edition of The World Bank’s Global Economic Prospects. The 150-page tome is, in large part, about the Western world, not emerging markets. The question at its heart is whether the “advanced” economies, having remained sluggish since the 2008 sub-prime collapse, are now staging a proper return to growth.
“For the first time in five years,” reads the opening lines of the World Bank’s report, “there are indications a self-sustaining recovery has begun among high-income countries – suggesting they may now join developing nations as a second engine of global economic growth”.
Economies across Africa and Asia, in other words, along with the emerging markets of Latin America and BNE’s home region of Eastern Europe and Eurasia, are performing quite well. These nascent capitalist societies are the “engine of global economic growth”, says the World Bank.
The report then poses the most important conundrum facing the world economy today: can the West now join the emerging economies and start to actually help, rather than hinder the global recovery given “the normalization of policy … the gradual withdrawal of quantitative easing”.
Back in the immediate aftermath of the Lehman collapse, few mainstream economists dared publicly to question QE. Financial markets were tanking. Western politicians (and police chiefs) were scared. So it wasn’t long before the too-big-to-fail banks got their “extraordinary monetary measures” – despite the warnings from history.
When America’s QE began in November 2008, it was billed as a $600bn program. Its British equivalent, starting five months later, was to be £50bn. Eurozone policy bosses dismissed sub-prime as “an Anglo-Saxon problem”, claiming the European Central Bank wouldn’t need QE to survive “America’s credit crunch”.
Since then, of course, the virtual printing presses have been at full pelt. Over the last half decade, the US has unleashed $3,200bn of QE, as the Federal Reserve has tripled its balance sheet. The ECB, hiding Euro-QE behind a wall of obfuscation, is catching up fast. The Bank of England has spat out £375bn of funny money, almost 8 times initial estimates, and now holds over a third of UK government bonds. Such rapid monetary expansion and self-financing of state debt is unprecedented in modern times. Yet it’s happened with barely any Congressional or Parliamentary debate.
The West now needs to wind-down QE, as this World Bank report highlights. In January, the Fed is to cut its $85bn-a-month money-printing habit to $75bn. Such “tapering” is a long way from tightening. Between 1913 when the Fed was founded and 2007, America’s monetary base grew to $800bn. Since then, under QE, base money has grown on average by $530bn a year for six years.
During 2014, even if Janet Yellen sticks to the “tapering” schedule, the Fed will print another $900bn in a single year. That’s if the Treasuries behave, equities don’t crash and the Fed’s political masters have the guts to see it through. If not, tapering will be even slower or may not happen at all.
Even under tapering, though, the Fed’s balance sheet will hit almost $5,000bn by the end of this year, compare to just $800bn when QE began. The Fed will have conjured up ex nihilo over 5 times more money in 6 years than it has in the previous century. Western central bankers, in general, have created the biggest monetary overhang, and blown the fattest bond bubble, of modern times.
No-one knows if this can be deflated slowly – including no-one at the Fed. Just the hint of tapering last May sent the 10-year Treasury yield spiraling above 3pc by the end of 2013, up from 1.76pc at the start of the year. The Fed, after all, just like the Bank of England, is the largest buyer of its own government bonds.
We could see another “taper tantrum” over the coming months, with Treasuries spiking again, sending higher borrowing costs rippling across the Western world. Tapering would then be postponed, with QE possibly getting faster before it starts significantly to slow.
What has all this got to do with emerging markets – not least those such as Poland, Turkey and Russia? Possibly quite a lot – in terms of short-term equity prices. Over the eight months since “tapering” was first mooted, global investors have become spooked about systemic dangers. Sentiment has switched to “risk off”, hitting emerging market shares disproportionately, despite their far superior fundamentals.
Since May, as tapering has come into view, the MSCI EM index of all emerging market equity indices has fallen 8pc, while the S&P500 has surged 15pc. The World Bank is now worrying aloud that if the QE unwind results in a “disorderly adjustment scenario”, with bond and equity markets overshooting, capital flows from the West to the emerging markets could “contract by as much as 80 per cent for a period of several months”, inflicting “significant economic damage and throwing some countries into crises”.
No matter that the Bank’s “baseline” scenario sees only a “modest retrenchment” in emerging market capital inflows and this is “the most likely outcome”. The FT still showcased “storm clouds” over the relatively fast-growing emerging economies.
If tapering goes badly, emerging market equities will obviously suffer. But so will all equities – and, given the gross excesses of QE, pumping up Western share indices to repeated all-time highs despite unconvincing growth and weak earnings, equities in “advanced” nations have much further to fall.
The big picture is that, over any medium-term investment horizon, the rising Eastern economies will grow faster than their Western counterparts, their companies displaying fatter margins. QE has done nothing to change that reality – even if the unwind is nasty.
The fundamental danger isn’t, anyway, that Western money quits the East. Capital markets across Asia, Latin America and Eastern Europe have become far deeper, and more resilient, in recent years. Western bank fragility and fiscal weakness – a plight highlighted by QE – means that the far bigger risk is that capital from the emerging markets pulls out of the West. Far from sneering at Eastern skies, the FT should look overhead.