China or US woes? Why there is a sell off in emerging market assets

The last one month has seen a broad sell off in emerging equities and currencies. A look at the performance of indices across a few key emerging markets over the last one month show that benchmark equity indices of Indonesia, Philippines, Thailand, Brazil and South Korea are down by 7.5%, 14%, 16%, 10% and 4% respectively. The currencies of these countries have fallen by 2%, 5%, 4%, 7% and 2.5% respectively. USD bond spreads over US Treasuries of Asian issuers have risen by around 30bps to 50bps.

The Sensex and Nifty have fallen by over 4.5% while the INR has weakened by over 6% against the USD over the last one month. USD bond spreads of issuers such as ICICI Bank have gone up by over 60bps.

[caption id=“attachment_868887” align=“alignleft” width=“380”]
Market sentiments hurt by the Fed received further set back of weak China economic data and Yen volatility. Sentiments are still down and it will take a while before emerging markets stabilize.[/caption]

Why this broad sell off in emerging market assets?

The fact that this sell off has been widespread suggests that the issue is more global macro than country specific. What is this global macro issue that is causing such volatility in emerging markets? Is it worries of China slowing down dramatically and hurting commodity and export dependent countries? Is it worries of the US Federal Reserve withdrawing monetary stimulus leading to the end of an era of cheap central bank liquidity? The reason for the sell off could also be the huge volatility in Japanese Yen and the Nikkei with the Yen rising by over 7% from lows and the Nikkei tanking by over 17% from highs.

The more important question on the sell off in emerging market assets is whether this is a longer term trend or a short term nervous bout of selling by global investors including hedge funds.

On the reason for the sell off, markets tend to take its cue from one particular factor and then try and tie everything else with it. The Fed is preparing markets for a withdrawal of stimulus and said last month that it will consider reducing its bond purchases in its next few meetings. The markets took this as negative sign as withdrawal of cheap liquidity hurts investments in risk assets. The sell off in emerging assets started post the Fed statement.

China’s economic data did not enthuse markets with export growth of just 1% in May against a 14.7% growth seen in April. Japanese bond yields rose on worries over inflation due to declining Yen that had lost over 20% over the last one year on the back of the Bank of Japan (BOJ) adopting a 2% inflation target. Markets that were hugely short the Yen, covered the shorts at lower levels on expectations of the BOJ talking up the Yen.

Market sentiments hurt by the Fed received further set back of weak China economic data and Yen volatility. Sentiments are still down and it will take a while before emerging markets stabilize.

The answer to the question on whether the emerging market sell off is a longer term trend or whether it is short term in nature is that it is more of the latter. Yes, Fed can lower and even stop bond purchases but given that the US economy is only healing with unemployment rate at 7.6% that is well above the levels of 6.5% for a healthy economy and inflation trending at 1.1% levels as of April 2013, it is unlikely that will be a sharp rise in US interest rates in the near future.

China slowdown is good for lowering inflation expectations as commodity prices are kept down while Bank of Japan will double its monetary base over the next two years. Emerging markets including Indian markets should stabilize and look to strengthen going forward.

Arjun Parthasarathy is the Editor of www.investorsareidiots.com a web site for investors.