Emerging Asian markets have attracted sizeable fund flows this year and have consequently performed relatively well. This performance was not necessarily the result of strong fundamentals, but more a perception of relative safety offered by these markets in a world of great uncertainty.
The unexpected slowdown of the US economy in the early part of the year raised concerns over what was just about the only appealing growth story within developed markets. The presidential election campaign highlighted the risks of potentially major policy changes in fundamental areas such as US adherence to trade agreements, its relations with Mexico and China, and commitments to alliances around the world.
Worries over Europe’s continuing economic travails were compounded by the British vote to leave the European Union (Brexit). This, combined with the migrant crisis and deepening fears of a banking crisis in Italy, made investors more conscious about extreme scenarios in Europe. The failure of the Bank of Japan’s (BOJ) monetary policy to weaken the yen and reignite inflation also contributed to the perception that central banks were generally running out of ammunition to keep deflation at bay in developed economies.
Against this, emerging markets in Asia appeared to offer relatively more hope. Even though they, too, faced challenges of their own, these challenges seemed to pale in comparison with those of developed markets. While worries about China’s economic direction did preoccupy investors, aggressive stimulus measures by the government seemed to be able to contain the risks. Elsewhere in Asia, there were more hopeful signs out of India, Indonesia, the Philippines and Vietnam, which lent confidence to the Asian story.
The recent market turbulence has caused bond yields to rise to multi-month highs, equity markets to tumble, Asian currencies to sink and commodity prices to weaken. All this raises the question of whether the macro fundamentals that supported the relative safety of emerging Asian assets have eroded?
Two important changes have, in our view, raised questions of the continued relative attractiveness of emerging Asian markets — the direction of monetary policy and political risks in Asia.
Monetary conditions may not be as supportive of emerging Asian asset prices as before
The easy monetary conditions that spurred capital flows into emerging Asia are now subject to two question marks: First, the speed at which the US Federal Reserve Bank will raise rates and second, whether policy shifts in Europe and Japan might disappoint expectations of ever more easing.
It is still difficult to discern precisely when the Fed will raise rates and how high it will go in this cycle. But, it is clear that policy is almost certain to see a shift in the coming year as the balance within the Federal Open Market Committee, which decides policy, seems to be shifting away from extreme hesitation to raise rates.
Fed officials have been encouraged by how resi-lient the US economy has been in the face of shocks such as Brexit. Moreover, their perception of relative risks appears to be evolving. As concerns over the US economy have ebbed, more of these officials have realised that the slowing of the economy in 1H2016 was due to one-off factors and that the US economy continues with its slow but steady recovery. Despite some fluctuations in data, the Atlanta Fed estimates 3Q GDP growth to be around 3.3%, roughly three times the pace of 1H2016.
In fact, some of these officials are now talking about the risks of not tightening early enough. For example, many observers had seen Eric Rosengren, the president of the Boston Federal Reserve, as a dove. But Rosengren surprised investors recently with relatively hawkish comments, where he warned that there was a “reasonable case” for a rate rise because of rising risks that the economy and financial markets would overheat. He further cautioned that low rates might cause some asset markets to overheat — pointing in particular to the commercial real estate market. True, while other Fed governors such as Lael Brainard have remained steadfastly dovish, the balance does seem to be shifting against the doves.
The question is not so much whether the Fed will raise rates in September or December — the really important question is what the pace of tightening will be. We think that the pace will be more aggressive than markets currently expect because of the likely trends in economic growth, unemployment, wages, inflation and financial risks:
• The US economy is set to deliver enough growth over the next 12 months to cause unemployment to fall close to full employment. Housing continues to recover; small and medium-sized enterprises are increasingly confident; and there are signs that the long drought in capital spending is beginning to turn around;
• In fact, labour shortages are already being reported in surveys. As these proliferate, wage growth should accelerate, alleviating one concern that the Fed has — workers have yet to receive the benefits of economic recovery;
• Given that the currently weak productivity growth is not likely to change, rising wages will tend to raise unit labour costs, which will filter through to higher inflation. Current worries that inflation remains too low will therefore dissipate; and
• Monetary conditions have been kept ultra-easy even as the emergency economic conditions that justified them disappeared a long time ago. History tells us that such inappropriately loose monetary conditions tend to cause distortions in the economy, especially in financial markets. As the economy pushes ahead, the kinds of distortions that Rosengren warned about will become more evident.
The results will be that rates will start rising in December and that the Fed will progressively indicate that it will keep raising rates at a sustained pace through 2017 and 2018.
Second, monetary easing in Europe and Japan will not offset US tightening. In Japan, the BOJ’s review of monetary policy will be released at the end of this month. Media reports suggest that the BOJ review will conclude that the economic benefits of the negative rate policy initiated in January outweigh the costs of such a policy. However, the BOJ is also likely to assess that there are limits to how negative rates could go, and attempt to placate criticisms that such a policy causes damage to, for instance, insurance companies and pension funds. In other words, while easing policy further, the BOJ will also signal to markets that negative rates cannot go too far.
Similarly, there appears to be a growing pushback in Europe to even more negative interest rates than the European Central Bank (ECB) has allowed. Sabine Lautenschläger, who is the vice-chair of the Supervisory Board of the ECB, recently argued against further cuts in interest rates. She believed that, with economic growth back on track and financial stability significantly improved even in the face of shocks such as Brexit, the case for further interest rate cuts seemed weak.
In other words, while Europe and Japan may well seek to ease monetary conditions, they are reaching the limits of monetary policy. Markets cannot expect ever easier monetary policies and ever more negative interest rates to boost valuations.
Risks in Asia are rising, mainly because of politics
As the US raises rates and as monetary conditions in Europe and Japan are no longer expected to be eased aggressively, investors will look at risk in emerging markets more rigorously. When they look at Asia, they will see a step change in political risks for many reasons.
More flashpoints that could intensify big power rivalries in Asia
North Korea has made significant progress in its efforts to build a nuclear capacity. Its recent tests of new missiles, warheads and nuclear weapons point to a steady upgrade in its offensive capabilities. It seems to be making progress in miniaturising warheads and launching nuclear-tipped missiles from submarines. In doing so, it has demonstrated the utter failure of the sanctions regime that the big powers have used to stop the North Korean programme.
In short, the US, Japan and South Korea are more threatened today than ever before — and they need to urgently find alternative means of stopping the North Koreans before they make so much progress that big powers such as the US and Japan are at risk. But such alternative measures — whether they be hard sanctions or military action — involve huge risks, including that of exacerbating tensions between China on one hand and the US and allies on the other.
Apart from North Korea, tensions continue to build over disputed waters and islands in the South China Sea and East China Sea as a more assertive China finds ways to entrench its claims against several of its neighbours, including Japan.
Domestic political concerns more evident
Investors will continue to be nagged by political dangers in some individual countries.
• In Thailand, medical bulletins on the king’s health in recent months appear to be preparing the Thai people for the worst. The risks associated with royal succession that investors had at the back of their minds will now come to the fore.
• In Malaysia, the risks are less dire but still of concern. Prime Minister Najib Razak has outmanoeuvred his opponents so far; he remains under pressure as his opponents try to form a united front against him and as they hurl more accusations of misconduct against him. There is more talk that the embattled prime minister might call an early general election — a risky gambit that could well turn out badly.
The bottom line: more challenging times for Asian markets
Asian markets will be helped by the fact that yields on major assets are likely to remain low for some time even as US rates rise — given the likelihood that overall global economic growth and inflation will remain low, and major central banks such as those in Europe and Japan will continue to ease.
However, as US rates rise, and expectations of very loose policies in Europe and Japan are disappointed, investors will scrutinise Asian macro fundamentals more rigorously than before, especially where valuations have already been stretched. In this context, even small disappointments in economic performance or policy management could produce outsized corrections in markets. Investors, thus, need to approach regional markets with more caution in the coming months.
Manu Bhaskaran is a partner and head of economic research at Centennial Group Inc, an economics consultancy
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