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Brian Tora: Emerging markets first to suffer as QE is wound down

Emerging market economies have been the first to feel the effect of the Federal Reserve’s winding down of QE but fears are growing that this will see a slowdown in global growth.

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Well, I can’t make up my mind whether deciding against making emerging markets the sole topic for last week was fortunate or a missed opportunity.

They have hardly been out of the news since but much of the action took place after I had put pen to paper. First India raised interest rates, then Turkey, followed swiftly by South Africa. Russia intervened to protect the rouble and problems continued in Argentina, Thailand and the Ukraine. Nobody can accuse the developing world of lacking excitement.

Behind all that is going on is the spectre of monetary easing in the US coming to an end. That there will be less of it was confirmed by the Federal Reserve Bank last week as it announced a further step on its tapering trail. At the rate at which the Fed is cutting back its bond purchases, quantitative easing could finally have finished by the end of this year.

This latest move was conducted on the watch of outgoing Chairman Ben Bernanke but nobody is expecting Janet Yellen, who will be in charge shortly, to vary the policy.

To understand why the actions of the US central bank is having such an impact on these emerging nations, you have to look back to the action taken by the developed world to the unfolding financial crisis more than five years ago. Such was the speed of economic retrenchment that central banks slashed interest rates to virtually zero in an effort to bolster growth. When this failed to do the trick, QE was introduced to further stimulate faltering economies.

QE involves the central bank buying bonds and other financial assets, driving down returns to investors as a consequence. In an effort to replace the income generated by these assets, money flowed into emerging markets where yields were higher. This had the effect of pushing up these currencies – something that many of these countries were less than happy with. Now the money flow has been reversed, with funds returning to the US where even economic prospects are looking rosier.

The consequent fall in these emerging currencies has helped push up inflation – a particular problem in India and Turkey. This helps erode any competitive gains a falling currency might deliver. In other words, we are travelling through another period of significant change, brought about by the ending of a great financial experiment that does at least appear to have brought some benefit. Many commentators, myself included, thought inflation would be the price paid. Ironically, it seems to be those countries not directly involved that have suffered.

One immediate effect of all this is likely to be a moderation of the growth achieved in many of these hitherto fast expanding economies. Brazil has already moved into reverse. Interestingly, it was Brazil that complained the loudest over the inflow of cash driving up its currency. Even China is seeing a slowdown – something that is having a knock-on effect for those businesses that have benefitted from the fast growing domestic market there.

The carnage in developing markets has unsettled sentiment in the developed world as fears grow over how this will all impinge on global growth. But it is not a picture of untrammelled gloom that is being painted. Mexico appears to be doing very nicely thank you, perhaps helped by its close proximity to the US. Other areas also seem capable of shrugging aside current uncertainty although the likelihood remains that life after QE will overhang markets for the foreseeable future.

Meanwhile, hats off to Bank of England Governor Mark Carney, who warned Scotland that remaining within the sterling currency zone, should independence be chosen, would come at a cost. His comments came as a stark reminder that if the eurozone is to remain intact, further financial changes will be necessary which might call into question Britain’s role in Europe in the future.

Brian Tora is an associate with investment managers JM Finn & Co

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