Yellow “Caution” tape is displayed outside of the New York Stock Exchange (NYSE) in New York, U.S. (Photographer: Michael Nagle/Bloomberg)

Emerging-Markets Calm Is Likely to Give Way to More Volatility

(Bloomberg Opinion) -- The calmer markets and the bounce in exchange rates at the end of last week make it tempting to declare the end of the summer turmoil in emerging economies. Those positive developments, along with increasing evidence of investor differentiation, naturally give rise to hopes that we are experiencing a repeat of early 2016, when heightened concerns about China-driven market disturbances gave way to a comforting restoration of capital flows, higher asset prices, and a far more supportive operating environment for individual emerging countries.

I share this hope and recognize the historical precedent. Yet there are four reasons to remain cautious.

  1. Prolonged market disturbances don’t always play out in a linear fashion: A few calm days don’t necessarily mean the end of a generalized disturbance. There are many historical examples of temporary snapbacks in the context of a bigger trend of continued market disruption. This is especially the case when spillovers, and possibly spillbacks, haven’t run their course, and when decisive circuit-breakers haven’t been put in place and triggered. It is too early to dismiss the possibility that the financial volatility of the last few weeks could destabilize some economic and financial fundamentals, leading to a return of market dislocations.
  2. Headline-country cases aren’t resolved: Neither Argentina nor Turkey, the two big headline cases, have produced a combination of policy adjustments and new financing that would place their economies on a secure path to stability. Accordingly, the market relief they experienced at the end of last week is more likely to have been the result of periodic portfolio position realignments than of a fundamental change in the underlying market dynamics. A more lasting improvement is possible if Argentina and the International Monetary Fund agree on a strengthened program with more favorable funding, and if Turkey finds a way to expand its policy response, including from its central bank, which will hold a meeting Sept. 13.
  3. The external environment remains uncertain: Emerging economies are operating in a fluid global context characterized by a growing divergence in performance among advanced economies, political uncertainties, a less stable international trade system, and evolving central bank policies. The immediate risks come from potentially destabilizing changes in the dollar and international financial conditions. Those developments feed into the “global factor,” which, as shown by the research of Helene Rey and others, can play a consequential role in driving domestic financial and economic variables in emerging markets.
  4. The net impact of recent changes in market structure remain uncertain: Finally, we haven’t learned enough about the impact of recent structural changes to the marketplace for portfolio investing in emerging economies. Specifically, it isn’t clear if these changes will dampen or amplify volatility during periods of heightened turmoil. This is true not just for the uptick in passive investment and the proliferation of new products, but also for changes in the way that crossover investors gain exposure to the EM asset class, the increase in local currency investing, and the rise in emerging-countries’ corporate-bond issuance.

Each of these four factors suggests we can hope for calmer days ahead for emerging markets but should plan for the probability of renewed volatility.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Mohamed A. El-Erian is a Bloomberg Opinion columnist. He is the chief economic adviser at Allianz SE, the parent company of Pimco, where he served as CEO and co-CIO. His books include “The Only Game in Town” and “When Markets Collide.”

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