EMs: Brace for long haul; it's going to be tough

Battered emerging markets are in for a long period of pain and will get only temporarily relief if the U.S. Federal Reserve holds its fire on a rate hike next week, analysts warn.

In fact the asset class, which for a long time was a darling for global investors, is not expected to see a sustained turnaround until a number of factors fall into place.


Aykut Unlupinar | Anadolu Agency | Getty Images

"This time a cathartic trading week will not be enough for a sustainable rally," Demetrios Efstathiou, head of CEEMEA Strategy at Standard Bank, said in a note on Tuesday.

"We need stability in Chinese economic data and commodity prices, and the first Fed hike well out of the way," he said.

If anticipation of the first U.S. rate hike in almost a decade wasn't enough to rattle emerging markets, countries from Brazil to India and Turkey are also coping with a sharp selloff in commodities and a slowdown in China's once-booming economy.

Rattled

Against this backdrop of turmoil, the World Bank chief economist Kaushik Basu told the Financial Times on Wednesday that the Fed risked sparking "panic and turmoil" in emerging markets if it raises rates at its September meeting.

International Monetary Fund (IMF) chief Christine Lagarde said at the weekend the Fed should not rush a move to lift rates.

For emerging markets, the fear is that a U.S. rate hike sparks large capital outflows from their economies into dollar-denominated assets and this leads to further market turmoil that dents economic growth.

Many emerging markets have seen net private capital outflows of about $300 billion in the past four quarters, according to the Institute of International Finance, a global group of financial institutions.

It says the scale of these outflows was similar to those last seen during the 2008 global financial crisis.

Not like 'taper tantrum'

The MSCI Emerging Market Index meanwhile is down about 14 percent from a peak in April.

"I think the Fed is concerned about China, about emerging markets in general – perhaps more so than in the past when they (policy makers) tended to be parochial," Rob Carnell, chief international economist at ING Commercial Banking told CNBC on Wednesday.

"They are beginning to wake up to the fact that what they do does have a broader impact on the rest of the world and they don't want to mess that up."

Nicholas Spiro, managing director at Spiro Sovereign Strategy, says the big difference between the current turmoil in emerging markets and previous bouts of volatility such as the 2013 "taper tantrum" and the 2007-08 global crisis, is a deteriorating economic outlook across these markets.

Economists say that the many emerging market economies have been reliant on either commodities or China to power growth and are now being hit hard by a rout in raw materials, itself linked to signs of weakness in China's economy.

South Korea, for example, is often viewed as gauge of export growth globally but last week it warned that exports slid 14.7 percent in August from a year earlier, suffering the biggest fall in six years.

Deutsche Bank forecasts emerging market economies to grow 4.1 percent this year, down from growth of 4.6 percent last year and 5 percent in 2013.

"It's bad enough from an external standpoint, with EMs caught between a tightening in U.S. monetary policy and sharp economic downturn in China," said Spiro. "What makes matters significantly worse is that domestic economic weaknesses are becoming more pronounced, particularly in Asia and Latin America."

Analysts said that while emerging markets were in stronger shape compared with the 1997-98 Asian financial crisis, sentiment was unlikely to improve for some time.

"As EM is seen as a commodity asset class and with now Asia under pressure from a possible future Chinese yuan depreciation, it will be hard to attract fresh inflows," said Efstathiou at Standard Bank.

"We therefore have more to go before we find the market bottom," he said.