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

The bond spreads on emerging market bonds are at their tightest level in years, despite the largest energy supply shock ever. It is unclear how long the current situation will last.

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? has now given way to a stronger rally.

Both the MSCI Asia ex Japan index and MSCI global emerging markets?index climbed by 3% on Wednesday to reach new records highs, which means that they are both 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 vulnerable to energy shortages have certainly underperformed. There has also been a noticeable weakness in the currencies. There is no panic on the market.

Even if the Middle East crisis subsides, the outlook for growth, inflation and policy is not a rosy one. Fiscal outlooks in many countries are deteriorating.

The International Monetary Fund revised down the growth of emerging and developing countries this year by just 0.3 percentage points, but there is a lot more dispersion beneath the surface.

Authorities in the most vulnerable economies have had to act to ease domestic pressure on prices and to reduce household burdens.

The IMF warns that in a worsening scenario in the Middle East the impact on the emerging economies would be nearly twice as great as on the advanced economies. The markets may be optimistic today about a possible framework for an agreement to end the conflict and reopen Strait of Hormuz. But we've seen this before without a permanent solution.

Investors in emerging markets are unusually calm, despite the fact that uncertainty remains high. What's the deal?

COULD YOU BE CALM OR "COMPLACENT"?

A major factor is the wave of hyper-optimism surrounding the artificial intelligence boom. 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 stock prices 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 has been larger than we saw in 2022. EM inflation will likely continue to move up.

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 the rise of nearly 80% in 2022. Food prices, inflation adjusted, would also still be lower. Food is a larger share of spending by consumers in EM countries. The pain is just beginning to spread through the system.

DANGEROUS OR DELICATE:

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

Exchange rate depreciation has been the main factor in keeping tightening under control.

Since the start of the war, the rupee in India, the rupiah in Indonesia, and the peso in the Philippines have all'slumped' to new lows. Most emerging currencies have also depreciated.

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 own set of risks, including higher inflation. Price increases that are rapid could scare away foreign investors and create a vicious circle.

Low exchange rates, however, are helping to keep EM financial conditions loose and support asset prices. It's a delicate dance. It could be dangerous as well.

You like this column? Open Interest (ROI) is your new essential source of global financial commentary. Follow ROI on LinkedIn and X.

Listen to the Morning Bid podcast daily on Apple, Spotify or the app. Subscribe to the Morning Bid podcast and hear journalists discussing the latest news in finance and markets seven days a weeks.

(source: Reuters)