beyondbrics

By Timothy Ash, head of emerging markets research, Royal Bank of Scotland

Most investors in emerging markets had a pretty good end to 2009, thanks to quantitative easing policies adopted by developed countries. The party spilled into 2010 – and, although the need for a mega clean-up operation (fiscal austerity) became clear, the Fed has come along with a reworked version of quantitative easing.

That means the festivities can now extend into another dawn where a new paradigm is in place: emerging markets offer higher growth from a lower base. Such catch-up potential does indeed exist. But beware: not all the hyped countries have the fundamentals to justify the new thinking.

The new quantitative easing – QEII – seems to offering the prospect of more of the same, in terms of keeping the “rates lower for longer” trade on. With the US indicating it is more than happy to de-base the dollar to try and re-inflate, much of the liquidity is trickling out again into real assets, commodities and emerging markets foreign exchange, credit and even equities.

Spreads/yields across the EM universe are already remarkably low/tight – resembling levels in the pre-Lehman heyday. We muse that we are in a new normal era of low growth and near zero inflation. It may even be true.

But I just think technicals have got way ahead of fundamentals at current levels, and we are back in a “liquidity momentum” trade similar to that seen in the first phase of quantitative easing.

I like EM a lot, and accept that these economies do offer catch-up potential on developed markets. They also invariably have much better macro balance sheets (lower public finance ratios, and strong external financing positions).

However, these are generally still poor countries with weak institutional structures, huge levels of income inequality, political fissures, difficult business environments (see the World Bank’s Doing Business survey) and high levels of corruption (see Transparency International’s rankings).

I am still not sure that these factors are now being priced in: the gush of developed-market QE is blinding us to the risks. Every day another EM country seeks investment – with ever-lower yields and over-subscribed issues. Investors are just thinking of the carry, and pushing ever further down the credit curve.

A new bubble is being inflated. It probably hasn’t yet reached a level of leverage which risks being pricked, but once we see signs of growth and inflation again in the G7+ the downside risks will be immense. I doubt that the EM decoupling theory will still hold water at that point in time.

This is of course a broad generalisation and within the emerging market universe there are economies that, from a balance sheet and broader assessment of fundamentals, arguably outscore their G7+ peers. The Czech Republic, Singapore, South Korea and Poland spring to mind, along with possibly even Chile, Brazil and others.

Yet there is a wider group of other emerging market economies, which, although they appear to have proven themselves during the global crisis, still have deeper institutional weaknesses. These countries probably include South Africa and, I would argue, Turkey. Turkey may well now deserve a much better rating, but it is difficult to argue that it has graduated from the EM universe.

We should recognise these limitations.

Related raeding:
[Guest post] Bulls are wrong on Russia, Timothy Ash, beyondbrics
Quantitative easing, FT Lexicon