As we approach the 10th anniversary of the global financial crisis, we are also closer to what economists like to call policy normalization or “taking away the punchbowl.” This is the time when the world’s major central banks begin to step away from the easy monetary policy they implemented in response to that crisis. In the US, markets increasingly think the Federal Reserve will begin to reduce its balance sheet this year. In the eurozone, CIO expects the European Central Bank (ECB) to announce this fall that it will gradually end its bond-buying program starting next year.
In the process of this anticipation, fanned by the synchronized recovery in world economies, investors are hanging on to central bankers’ every word, parsing their speeches, press statements and testimonies for their policy intentions. This is why we think the environment is ripe for policy mistakes and misunderstandings between monetary authorities and market participants.
We are therefore entering a “tantrum-prone” world where markets could misinterpret policymaker comments as hints of sooner-than-expected monetary tightening – and overreact as a result. Based on past tantrum episodes, the outcome could be a global sell-off in both bond and equity markets.
The dramatic “taper tantrum” of 2013 is still fresh in investors’ minds. It occurred after then-Fed chief Ben Bernanke broached the idea of tapering the Fed’s bond-buying program. In three months, 10-year US Treasury yields soared by close to 100 basis points. Back then, emerging market equities, credit and currencies did even worse than developed market counterparts. During the second memorable episode – the Bund tantrum of 2015 – most emerging market assets also underperformed overall, although to a lesser extent.
Are emerging markets today better prepared for another big tantrum? We think so. In the years since the Fed episode, all emerging market regions, and most countries in these regions, have built up their current account and international reserve positions while their currency valuations and real interest rates have improved, making them less vulnerable to external shocks.
For proof of this resilience, look no further than the “tantrum lite” of the past couple of weeks, after ECB chief Mario Draghi said “deflationary forces have been replaced by reflationary ones”. That statement led to a sell-off in developed market assets, and although emerging market assets also suffered, they did not meaningfully underperform.
Of course, several pressure points could undermine this resilience: the continued debt buildup in China, the sizable twin deficits in Turkey and South Africa, and the persistent risk of fiscal slippage in Latin America. Overall, emerging markets’debt-to-GDP ratios have also worsened. The good news is most of the increase has been in domestic rather than external debt, and most countries have lengthened their debt maturity profiles.
In sum, CIO’s base case is that policy normalization by the Fed and the ECB will be gradual and well telegraphed. In addition, global growth can help offset modestly higher interest rates. Nevertheless, emerging market assets should be better prepared for the tantrum-prone world we might face in the months ahead.
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