ROI-Emerging markets defy energy shock. But how long will it last? McGeever

The bond spreads on emerging market stocks have been tighter than ever in recent years, despite the largest energy supply shock in the history. It is a question of how long it can continue.

According to the Institute of International Finance, emerging markets experienced a strong sell-off in March.?EM equities recorded their largest outflow in over 20 years. This rout was followed by an even stronger rally. Many observers would have never imagined this resilience.

On Wednesday, the MSCI Asia ex Japan index and MSCI Global Emerging Market Index both rose?3% each to new record highs. This means that they are now more than 20% higher than their lows of March 31.

In fixed income, government bond yields are increasing, but the JPMorgan EMBI Spread between emerging-market dollars and U.S. Treasuries has returned to pre-Iran War levels, and is close to its tightest level since 2013.

Corporate bond spreads have recovered even more dramatically. JPMorgan’s CEMBI Index yield spread against Treasuries was 205 basis points on Tuesday, the smallest since August 2007.

The asset prices of the countries that are most affected by the energy crisis have been underperforming, and currencies have also suffered. There is no market panic.

Even if the Middle East war subsides, the outlook for growth, inflation and policy is not a rosy one. Many countries are experiencing a deteriorating fiscal outlook.

The International Monetary Fund (IMF) has revised down the growth of emerging and developing countries this year by just 0.3 percentage points, but there is a large degree of variability beneath the surface.

In fact, the authorities of those countries most susceptible to rising fuel, fertilizer, and transportation costs had already taken action to ease domestic price pressures.

The IMF warns that in a worsening scenario in the Middle East the impact will be nearly twice as great on emerging economies than on advanced economies. The markets may be optimistic today about a possible framework for a peace deal that would end the conflict and reopen Strait of Hormuz. But we have been in this situation before without a permanent solution.

Uncertainty is high but EM investors are unusually calm. What's the deal?

CALM OR COMPLACENT?

Hyper-optimism around the artificial intelligence boom is a clear factor. Taiwan and South Korea's stock markets, which are rushing to supply the hyperscalers in America with semiconductors in an insatiable manner, have seen their respective stocks rise by 30% and 45% in the past six weeks.

Investors might also take comfort from the fact that EM inflation hasn't spiked as much as during the last energy crisis in 2021-22, when global supply chain was snarled by the pandemic and Russia's invasion in Ukraine.

Citi economists report that the annual inflation rate for emerging markets, excluding China was 3.5%. This is the highest level in more than a year but it's still below the 2022 peak of 8%.

This complacency, however, could be dangerous. The rise in oil prices is much greater than we saw back in 2022. EM inflation will likely continue to increase.

Similarly, a rise of 20% or more in food prices globally in the next few months, which is what economists at HSBC expect, would be well below a near-80% increase in 2022. Food prices, inflation-adjusted, would also still be lower. Food is a larger share of the consumer budget in EM nations, but the impact is still catching up.

DANGEROUS OR DELICATE:

Financial conditions are often the deciding factor in asset prices. Goldman Sachs global EM financial condition index rose by 100 basis points to 100 basis point in March after the war began on 28 February. This has now eased, and it is not as bad as the 350-basis-point spike following the Russian invasion of February 2022.

Exchange rate depreciation has kept the 'tightening' in check.

The rupee of India, the rupiah of Indonesia and the peso de Philippines have all fallen to "record lows" and many emerging currencies have also suffered a significant decline since the start the war.

A weaker currency, all else being equal supports export-led growth. It also cheapens assets in the country for foreign investors who are dollar-rich.

A currency in a downward spiral comes with its risks, including higher import?inflation. Price increases that are rapid could scare away foreign investors, creating a spiraling cycle.

Low exchange rates, however, are preventing EM financial 'conditions? from becoming too tight and supporting asset price. It's a delicate dance. It could be dangerous as well.

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(source: Reuters)