Every story begins with a new chapter and on June 19, 2013 began one such story. This was the story of an impending economic collapse— that of the emerging markets (EMs). The press conference then Fed Chairman Ben Bernanke held that day will forever be etched in our memories for it caused ripples, albeit financial, across the world.
However, what were ripples in the west became tsunamis in the east. Foreign investors who had invested in emerging economies were the first ones to panic. Expecting an approaching truck in the form of higher borrowing costs, they fled. Markets plummeted, currencies took a beating, obituaries poured in and central banks bolted.
Is it possible for the Fed to phase out QE without causing economic instability, both in the United States and its trading partners? As testified by the past, absolutely not. In cognizance of this, is the Fed’s decision to taper bond purchases a good one? Undoubtedly yes.
To understand the future implications of the deconstruction of QE requires a solid macroeconomic understanding of the events that immediately followed Bernanke’s announcement.
It is no secret that most emerging economies, accounting for more than half of the world’s GDP in PPP terms, have massive Current Account Deficits (CAD). The foreseeable future of these deficits took a turn for the worse when the currencies of these EM’s got a giant beating. The Indian Rupee fell about 15% and the Brazilian Real, about 20%. However they weren’t the only ones that plunged. The Indonesian Rupiah, the Malaysian Ringgit and the Turkish Lira fared poorly too. Given their large imports and the erosion of their currencies, the CAD for emerging economies was exacerbated even further. Furthermore, aware of the fact these emerging economies will have to pay more to borrow money in the future, foreign investors who had buoyed these economies till now retreated to the west. Then to arrest this free fall of currency values and to combat already high inflation, intervened the central banks of Turkey and India, raising not only repo rates but also likelihood of stagflation.
This tumultuous environment, however, wasn’t confined to emerging economies. Western capital markets, reacting to a fear of liquidity crunch, fell too. It was rather ironical that a measure, announced to acknowledge the improving health of the American economy, culminated in the Dow falling 200-points. Bond prices reacted sharply as well, their fall sending yields higher. As expected, the dollar appreciated.
Now that almost a year has elapsed since these events, let me present my prognosis of what the future holds for us:
I am of the belief that the capital markets of a country are in most cases, an accurate reflection of the health of its economy. This is so, for they reflect investor sentiment— a consolidation of future expectations investors have of the world economy.
The MSCI emerging markets index has mostly stabilized, the Dow has all already breached its all time high, the FTSE which reacted sharply to the announcement of tapering has recovered too, and the HSI and Nikkei 225 are also faring rather well. The future expectations that investors have of the world economy look rather rosy.
Moreover there is ample reason to believe that these capital markets have already factored in the long-term effects of Fed’s actions. This conjecture backed by Eugene Fama’s Efficient Market Hypothesis which simply argues that the prices today are an accurate representation of the expectations for tomorrow. Therefore, given that the plans of Fed have been in the news for almost a year now, there is ample reason to conclude that the tapering of bond purchases will cause lesser instability in the future.
However, unsubstantiated claims hold little water.
Emerging markets, despite reacting sharply to Bernanke’s announcement, await a second economic ascent. In light of China’s slowing growth, astronomical domestic debts, diminishing workforce and a mighty property bubble, I expect future investors to relocate their investments to other countries such as India, Indonesia, South Korea and Latin America. This is so because given their favorable demographic dividends and in S. Korea’s case, a comparative technological advantage, these countries can become competitive manufacturing economies. Moreover, considering their falling currencies, they can achieve an edge in exports— a palliative for their current state of CAD. This seems even more promising in the wake of the observation that the sharp fall in the valuation for Emerging Markets has corrected a few bubbles, which might have started forming in these economies, thus returning most valuations, back to their fundamentals.
Considering these observations, most emerging markets, save deeply troubled ones like Brazil and Argentina, present attractive buying opportunities, for at the moment they are severely undervalued.
Coming to Europe, markets, after a temporary hurdle in June 2013, are all set to embrace their all time highs. Moreover, the economic condition of the EU, owing to ECB’s active intervention, is steadily regaining its health. Britain, thanks to its rising employment and earnings, is set to grow at 2.6% this year— a statistic that was positively revised in February 2014.
In Japan, Abenomics, to an extent, seems to have cured the country of its sluggishness. Nikkei, a little down from its all time high, is still quite high. As of 16 February 2014, it is boasting of a 35.97% 3-year change. Moreover, with the improving health of the world economy and its attractively valued currency, the future of the export-intensive Japan, I believe, looks promising. The yield of the Japanese Government’s 10-Year bonds is rather low— reflecting high demand, in turn insinuating a rosy future.
Latin America, however, seems to be an oddity. Economists believe that Brazil is in the midst of a recession— more precisely, a stagflation. Argentina, with its yawning CAD and meager foreign reserves doesn’t look very promising either. The Mexican 10Y bond yields too, are at an all time high. Therefore, I am of the view that the fortunes of Latin America that have long been susceptible to the whims of the world economy will soon take a turn for the worse, leaving the region to languish in its own misfortune, if the national governments don’t intervene with sound policies.
Having described an accurate picture of the world economy almost a year after the announcement of QE, there is ample reason to conclude that the overall macroeconomic outlook for the world looks encouraging.
Therefore even though the Fed’s announcement on June19, 2013 did cause ‘ripples’ in the west and ‘tsunamis’ in the east, the volatility in the global financial system seems to have decreased significantly. In hindsight, it seems as if the instability caused by Bernanke’s announcement was temporary. As in Indian student studying in the United States, my fees too, has more or less stabilized, after increasing at one point, by almost 20%! On a more serious note, if one is to analyze the situation of the world economy today, one will observe that investors have favorable expectations for the future— the future without QE.
Taking all this into consideration, has the announcement of QE tapering caused instability in the global financial system? Yes. Will actual QE tapering cause further instability in the same system? As not only this essay, but also the markets of today testify, certainly not.
- The market reaction to Bernanke’s announcement on June 19, 2013 and the recovery which followed is evident in the following charts
MSCI Emerging Market Index:
 Indices procured from Financial Times, bond yields from Bloomberg.