Déjà Vu All Over Again?

QMA expects higher chance of continued stress in emerging markets versus “Asian contagion” as the Fed taps the brakes

November 02, 2018

More than 20 years ago, the global economy faced a very similar situation to the one it finds itself in today. Tech stocks were soaring, the U.S. was growing at a robust pace, and a global expansion getting long in the tooth was beginning to wobble.

 

When the Fed Taps on the Brakes, Someone Flies Through the Windshield

Part of the problem was that after a long period of accommodative monetary policy, the U.S. Federal Reserve had begun to hike interest rates, raising borrowing costs and increasing the foreign exchange (FX) pressures on certain markets around the world. As QMA notes in its Q4 2018 Outlook Review PDF opens in a new window, there is a saying that when the U.S. Federal Reserve (Fed) taps on the brakes someone flies through the windshield. In 1997, it was the heavily indebted Asian Tiger economies of Thailand, Malaysia and the Philippines that gave rise to the Asian Financial Crisis. In the summer and fall of 2018, the most immediate signs of distress have been felt in Turkey, Argentina, Brazil and other emerging markets (EM) with high current account deficits and vulnerable currencies. Now, as then, a Fed tightening cycle is exposing the weakest links. The question, as always, is whether the damage can be contained before it spreads more widely.

Fed Rate Hike Cycles and Crises

Line chart showing the U.S. Federal Reserve Target Rate from January 1970 to September 2018. The chart highlights the following crisis periods: Franklin National in 1974, First Penn in 1980, LatAm in 1982, Continental Illinois in 1984, Black Monday in 1987, S&L Crisis in 1990, Mexico in 1995, Asian Financial Crisis in 1997, Russia/LTCM in 1998, Nasdaq Collapse in 2000, and Subprime in 2007. It also highlights Turkey and has a question mark next to others in 2018.

Source: QMA, FactSet as of 9/26/18.

QMA’s answer to that question, detailed in its Outlook, is yes. On balance, the firm’s Global Multi-Asset Solutions Team (GMS) believes that the underlying strengths are such that the global economy should be able to ride out the current problems emanating from EM and continue growing through 2019. But, as with a number of the factors the team is watching, this is not a slam dunk. They break down the odds roughly as follows:

Scenario 1: Asian Contagion Redux (30%)
  • A Ton of Shaky Debt Seduced by cheap financing, EM economies have ramped up their levels of external debt to about 30% of GDP. While this is below the levels of the late 1990s, a large share of it is denominated in hard currency, such as the euro and U.S. dollar. Further, anecdotal evidence suggests that most of the debt is poorly hedged. So, while most EM countries look much stronger compared to 20 years ago on the basis of the steady buildup of their FX reserves, they are still vulnerable to the risk of their debt payments ballooning.

  • Trade Wars The tensions that have hindered global trade activity add to the currency and debt pressures because they curtail countries’ ability to export freely and replenish hard currency reserves.

  • Higher Oil Prices The rise in oil prices over the past year puts more pressure on commodity-importing markets such as China and India, spurring more demand for FX reserves and the potential for a cycle of inflation and monetary tightening even in less indebted EM countries.

  • Back Door to DM There are clear ways that EM troubles could enter the developed world – for example, EM corporate debt defaults hitting European banks.

Scenario 2: Continued Stress but No Pandemic (70%)
  • Fewer Pegs In contrast to 1997, most EM currencies today are free-floating and no longer pegged to the U.S. dollar. This gives governments more latitude in managing their FX reserves, allowing for more gradual monetary adjustment that has a less abrupt effect on their economies.

  • China Factor China is a much bigger part of EM than it was in 1997, accounting for some 40% of EM GDP. China’s debt is mostly internal, and foreign currency reserves are extensive, giving government substantial leeway for “doing whatever it takes” to maintain financial stability and economic growth.

  • More Corporate Most of the outstanding debt in EM today is corporate debt, limiting the risk of sovereign defaults. Corporate defaults transmit to banks, which are more likely to be rescued by governments.

  • Still Focused on FX For all the distress seen so far, the EM economies are by and large still growing, corporate fundamentals are sound, earnings expectations remain in the low double digits, and local currency returns on EM equity and debt are substantially higher than in hard currency terms, suggesting that so far the crisis has mostly been a currency one.

So, in sum, QMA sees more reason to believe that EM stress will not morph into a full-blown debt crisis. That said, QMA does note another parallel to ’97. When the Asian crisis caused markets around the world to tumble, the Fed halted its tightening campaign, and a year later it cut rates in response to the Russian sovereign debt default and the meltdown of hedge fund Long-Term Capital Management. In the short term, the move had the desired effect. Stocks recovered from a sharp sell-off and U.S. economic growth stayed firm. But it also wound up turbocharging the next (and final) leg of the dot.com bubble, which led to the tech wreck of the early 2000s. 

While it is hard to imagine the Fed would return to cutting rates any time soon, if the current EM crisis were to somehow trigger more widespread financial damage, the Fed’s pace of tightening could very easily slow. Three or four hikes next year could turn into two. Or one. This, in turn, could prompt still-buoyant liquidity to flood markets segments with the strongest underlying fundamentals. 

In other words, it is not beyond the realm of possibility that one way this bull market ends is with the FAANG stocks going parabolic for a time before a major crash circa early 2022. To be clear, this is not QMA’s most plausible scenario. However, it does play into why the GMS team, after dialing back risk a bit more in its portfolios, maintains a slim overweight to global equities relative to its policy benchmarks. Although economic uncertainty is increasing, the near-term risk of a global downturn remains low. Moreover, there continue to be scenarios under which the bull-market expansion goes on yet another semi-extended run.

To cite another common saying, history doesn’t repeat itself but it often rhymes.

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