“DM is the new EM”, proclaims Morgan Stanley strategist Gerard Minack in a client note on Wednesday. Indeed, amid Greek debt woes and fears of contagion, there has been a steady and pronounced global shift in investor concerns away from the stability of emerging market debt to – yes, the new big paranoia centre, developed markets.
Minack neatly sums it up as “a role reversal without historical precedent” - and that shift, he says, is a key factor supporting Morgan Stanley’s forecast for a two-track global recovery: “Tepid DM, robust EM”. Explains Minack (our emphasis):
It gives EM policy-makers greater ability to respond if the expansion falters. It arguably reduces risks for EM equities versus DM. Our view is that DM sovereign stress may be reduced, in part, by public sectors’ pushing the burden back to the private sector (tax increases/spending cuts/compelled debt buying).
Sovereign stress is now largely a developed market phenomenon, he reasons, continuing:
First, EM budget balances were in better shape than DM coming into the crisis. The policy response in terms of conventional fiscal stimulus was broadly similar in both. According to the IMF, the structural primary budget balance in the G20 developed economies widened by 3.6% of GDP over 2007-2010. The change for the largest 20 emerging economies was 3.0% of GDP. With a better starting point, EM budget deficits are expected to be significantly smaller than DM.
Second, he points out, “faster economic recovery means quicker improvement in EM budget balances”.
Third, non-conventional fiscal measures amid the financial crisis were “significantly smaller in EM” than in developed economies, and added to the public sector’s financing task or created a contingent liability. For now, he says, “it’s unclear what the final cost will be”, adding:
According to the IMF, the announced or pledged measures amounted to 17.4% of GDP in developed economies, and only 1.0% of GDP in emerging economies… One reason why these measures were smaller in EM than in DM is that EM banks were, on average (and this obscures great diversity), in better shape than DM banks were.
Because of the size and uncertainty surrounding non-conventional fiscal supports, forecasting the outlook for budget balances and public sector debt is “unusually fraught”, notes Minack. But the bottom line is clear, at least to the strategy team at MS: a wide – and widening – gap between public sector debt levels in DM versus EM.
This gap, says MS, should lead to a divergent trend in sovereign ratings between DM and EM. Minack cites Viktor Hjort, MS’s head of Asian credit, who warns that the key risk to Asian credit is not home-grown, but contagion from the developed economies.
For now, EM equity markets are arguably not being rewarded for their better fundamentals, adds Minack. But MS’s strategists think this is a matter of time, and predict a better second half for EM equities. Concludes Minack:
Given our cautious view on DM equities, the best advice seems to be to expect EM upside, but protect against the downside.
Indeed, notes FPTradingDesk, the battered balance sheets of countries like Greece, Portugal, Spain and Ireland make the fiscal positions of most emerging markets “look strong by comparison”.
But it quotes Robert Buckland, Citi’s global investment strategist, saying that while more contagion is likely to stem from sovereign credit concerns, including a delay in the withdrawal of cheap money, the global fallout “should not be severe enough to drive a double-dip recession”.
Among various resolutions for big fiscal deficits, “some are positive for equities, others are not,” Buckland told FPTradingDesk, noting that cheap valuations should provide some protection against further disappointments for global stocks.
Nevertheless, in Buckland’s view, equity investors should avoid regions where fiscal issues are most acute until the problems are seriously addressed.
Citi economists forecast that of the 45 countries in the MSCI All Country World Index, four will have larger deficits than Greece in 2010 – representing more than 10 per cent of annual GDP, the blog continues. Japan, the UK and the US have “some of the most troubling positions”, although Japan and the US are deemed less of a concern, while the UK “is an economy that looks to be experiencing rising inflation, which may put pressure on the cost of financing”, noted Citi’s Buckland.
Emerging markets – where governments have sound balance sheets and companies offer solid growth – “will continue to benefit from cheap global liquidity”, he added. Cold comfort for the DMs.
Related links:
Coming next for hedge funds: the Greek inquisition – FTAlphaville
Sovereign risk and EM bulls and bears - FTAlphaville
William Pesek: Goldman’s contagion warning is Greek to markets - Bloomberg