Emerging-Market Turmoil Enters New Phase as Fed Takes Back Seat

  • South Africa's Zuma whipsaws markets with finance chief picks
  • Economic weakness magnifies political risk, policy importance

Impeachments, ministerial sackings and warplanes.

As if emerging-market investors didn’t have enough to worry about with the Federal Reserve poised to end a seven-year era of near-zero interest rates, political turmoil has buffeted developing economies more than normal in the past few weeks.

South Africa’s rand whipsawed after President Jacob Zuma named a second finance minister in four days and Polish stocks slumped to a six-year low amid a policy shakeup by the new government. Brazil was on the brink of impeaching the president, while Turkey’s standoff with Russia over a downed warplane triggered a selloff in lira assets.

“We’ve seen political risks come to the fore,” said William Jackson, a senior emerging-markets economist at Capital Economics Ltd. in London. “The timing couldn’t be worse. Those countries where political risks are excessive are likely to suffer a double whammy” if there’s more turbulence following the Fed rate increase, he said.

While investors have become accustomed to emerging markets that are under pressure following the collapse in commodity prices and amid the prospect for higher interest rates in the U.S., these domestic shocks are a reminder that developing nations are also susceptible to local political and economic risks.

Bullish Strategists

The latest upheavals come just as strategists from Bank of America Corp. to Goldman Sachs Group Inc. were saying emerging markets are poised for a turnaround following three years of losses. The banks signaled cautious optimism late last month, explaining that their hopes aren’t a reflection of improved fundamentals, but more that investment sentiment is so depressed that even a marginal rise would be enough to drive up assets.

But the optimistic sentiment soured last week.

South Africa roiled investors after Zuma dismissed his finance chief on Dec. 9 and replaced him with the little-known lawmaker. The rand tumbled 9.6 percent in the five days, breaching 16 against the dollar for the first time. The currency recovered some of those losses on Monday after the appointment of a former finance minister to the post. It was little changed at 15.1108 per dollar at 9:38 a.m. in Johannesburg.

The rush by Poland’s Law & Justice party to push ahead with plans to tax bank assets, ease rules restraining public spending and revamp the Constitutional Court, which keeps politicians in check, triggered a selloff that sent the zloty to the weakest versus the euro in almost a year on Dec. 14.

Strong Institutions

Unpredictability has always been one of the core risks in emerging markets, said Viktor Szabo, who helps manage $12 billion of emerging-market debt for Aberdeen Asset Management Plc in London.

“Something you should really keep an eye on as an emerging-market investor is the strength of the institutions. The problem comes when those institutions are being dismantled” as they are in Poland, he said. Szabo said he is bearish on Poland and South Africa and bullish on Argentina and Russia.

Brazil’s real has tumbled 32 percent this year, the biggest decline among 24 emerging-market currencies, as President Dilma Rousseff struggles to find support for measures to reduce the deficit and avoid additional credit-rating cuts while her popularity plunges and the economy shrinks.

Emerging-market currencies, stocks and bonds are headed for a third year of losses as a slowdown in China is curbing demand for raw materials, while higher U.S. interest rates may trigger capital outflows. Investors are on course to take $540 billion out of developing countries this year, the first net capital outflow since 1988, the Institute of International Finance said in October.

Political Instability

While political instability has traditionally been a major risk for developing-market investors, what’s unique today is that volatility is being driven by local issues rather than the “big super-power confrontations,” according to David Rolley, who helps manage $32 billion as vice president of global fixed income at Loomis Sayles & Co.

“Whenever global growth is slow, living standards don’t improve and when living standards don’t improve, there’s a greater risk to look for easy policy answers that allows for mistakes,” Rolley said Dec. 3 in New York.

While Poland’s new government pledged to increase spending and roll back the retirement age to win elections in October, Rousseff chose actions such as gasoline price controls to gain support, driving foreign investors away and damping domestic business.

Developing countries are more vulnerable to the threat of policy missteps in times of economic weakness than their more advanced counterparts because they lack institutional strength, G. Scott Clemons, chief investment strategist at Brown Brothers Harriman, said.

“Emerging economies haven’t had to engage in structural reform any more aggressively because up until recently there’s been economic growth,” Clemons said. “There’s a natural reluctance to engage in reforms during periods of weakness, and it’s a cynical conclusion but the most likely scenario is that governments will pick the lowest hanging fruit versus undertaking a full overhaul.”

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