Following a rapid sell-off in global risk assets last week with the epicentre in Emerging Markets, there have been tentative signs of stabilisation in some markets. The Turkish central bank surprised by delivering a higher-than-expected rate increase of 425bp and despite the scary name the Chinese trust product ‘Credit equals gold #1’ (CEG#1) saw a softer default than feared, see China: Orderly default of trust product kicks the can ahead, 27 January. South Africa also hiked by 50bp and even India increased rates despite very little impact on its currency from the latest turmoil.
At the same time, new countries such as Hungary and Poland have been drawn into the turbulence seeing a weakening of their currencies in the past days. Hence the overall situation is still quite fluid. The question is whether the recent sell-off in EM assets and correction in general risk markets will soon be over or whether there is more in store. We continue to recommend caution and to await clearer signals of stabilisation before raising risk again.
A few factors that speak in favour of stabilisation.
The immediate event risk has been reduced. The threat of a disorderly default of CEG#1 is behind us and there are also signs that Chinese monetary conditions have eased somewhat over the past days. In addition, central banks have shown willingness to take decisive action to stem the sell-off in currencies.
India and Indonesia were not hit this time. In last year’s two EM sell-offs there was a lot of focus was on these two countries that saw a significant weakening of their currencies. A major part of the reason why India and Indonesia were not hit this time is increased credibility following rate hikes but also the fact that their current account balances have improved significantly following the currency depreciation last year.
Macro environment in developed economies is strengthening. The data flow out of the US, Europe and Japan continues to be strong. Over the past week the German IFO rose to a new cycle high and US GDP growth for Q4 was published at 3.2%. The stronger macro backdrop supports overall risk sentiment and will also be a supportive factor for Emerging Market exports. A country like Turkey should see a rebound in exports from the strong currency weakening as well as stronger growth in Europe. This will help reduce the external imbalance.
Emerging Market currencies closer to fair value – and stocks are no longer ‘overbought’. Following the strong sell-off several of the currencies have corrected enough relative to what we estimate as fair-value level. This is for example the case for the Turkish Lira. Hence, if confidence can be restored and panic avoided, the case for further depreciation is not strong. Going into the crisis many stock markets were also overbought. This is no longer the case following the recent correction.
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