This week in global macro, the emerging markets reminded us that they are, well, emerging markets. The Egyptian crisis may have moved towards resolution, but there are risks of contagion elsewhere in the region. India continues to be the worst performing stock market of the year, and China is slowing under the weight of tightening monetary policy.
Developed equity markets continue to out-perform, although headline inflation is rising, notably in the UK. Although many people are claiming that the Bank of England is losing credibility, that is not yet showing in the gilt market. In the US, there were some signs of greater hawkishness from certain members of the FOMC, but none where it really counts – which is in the minds of Ben Bernanke and his senior lieutenants. The US equity market ended the week at its highest level since June 2008.
This week, I learned that:
1. Emerging markets really are emerging markets, after all. Emerging equity markets have achieved a cumulative annualised return of 13.2 per cent since 1999, while developed markets have eked out returns of just 0.6 per cent. Many investors have made their careers on this single trade. 
However, it can no longer be taken for granted that emerging markets will out-perform their developed counterparts.
With events in Egypt reminding us of the political risks in these economies, and the Indian telecom investigation highlighting compliance risks, the markets have been asking for a higher risk premium to hold emerging market equities.
Relative valuation no longer provides any reassurance. The price-to-book ratio in the emerging world now stands at 2.3 times, while that in the developed world is lower, at 1.9 times. Given the greater inflation risks in the emerging world, and the prospects of greater monetary tightening, is this valuation premium really justified? I would need some convincing, especially since….
2. The Chinese economy is slowing down as monetary policy is tightened. I have argued repeatedly in earlier blogs that China is the only one of the major economies which is slowing down at present. And monetary policy is being tightened further. Last week, 12 month interest rates on bank deposits were increased by another 0.25 per cent to take them up to 3.00 per cent. Yet that remains about 12 per cent below the current rate of growth in nominal GDP, which is not exactly a compelling incentive to save.
As a result, warnings from western investors about the developing “bubble” in residential and commercial property prices are becoming louder. I doubt whether the Chinese property bubble will burst with real interest rates as low as they are right now, but a progressively slowing Chinese economy is certainly not good for Asian stockmarkets. They fell by over 4 per cent last week, the worst performance in many months.
3. After the Egyptian revolution, contagion to other Arab countries appears likely. The main question for global markets, however, is which Arab countries? I was intending to produce an index of “contagion risk” (based on factors like the share of the population under 25, indices of corruption and democratic rights, and GDP per person) but The Economist got there first. According to their “shoe thrower’s index” index, Egypt was the third most likely Arab country to face political unrest, with an index of 65 out of 100.
Other countries with similar levels of risk are Yemen, Libya, Syria and Iraq, all of which have seen signs of trouble already. But none of them (not even Iraq) is a really significant producer of oil. Encouragingly, many of the key oil producing states, like the UAE, Kuwait and Qatar, are right at the bottom of the risk table, with index readings between 20 and 30. Saudi Arabia is around the middle of the league, with a worryingly high risk index of slightly over 50. More than ever, that is the country for global investors to watch.
4. The central banks in developed countries are facing mounting criticism. The central bank in the eye of the storm at present is the Bank of England, which is being accused of losing its credibility after failing to raise interest rates last week. We will learn more about their thinking when the February Inflation Report is published next week. But I do not see much sign that they are losing their anti-inflation credibility from the behaviour of the financial markets.
It is true that government bond yields have been rising in the UK, but no more than we have seen in other developed economies. If the markets really were worried that the high rate of UK inflation may become permanent, the gilt market would surely be in much worse shape.
Meanwhile, in the US, some members of the FOMC have hinted in recent days that they are concerned about the Fed’s dovishness. But this did not change the tone of Ben Bernanke’s testimony to Congress on Thursday. It was virtually identical to his previous dovish pronouncements. Only when this finally changes will financial markets really begin to sit up and pay attention.
5. It was the 100th birthday of the American Economic Review. Thanks to Paul Krugman for pointing this out. The American Economic Association has published a list of the 20 most influential articles carried by the Review in the past century.
My own personal favourites on the macro front are the Cobb/Douglas piece which invented the standard production function in 1928; the Milton Friedman lecture in 1968 which demolished the trade off between unemployment and inflation; the Robert Shiller study in 1981 which showed that stock markets are far more volatile over short and long period than they should be; and Krugman’s own piece in 1980 which amended the law of comparative advantage to explain the dominant pattern in global trade flows.
Sharing their hundredth birthday with the AER this year are Ronald Reagan, Tennessee Williams, Ginger Rogers, Phil “Sergeant Bilko” Silvers and “I Love” Lucille Ball. The AER has been more influential than any of them, except of course Sergeant Bilko.
