Emerging markets: Volatility is part opportunity and part trap

The US Federal Reserve triggered a storm in developing countries this year when it announced plans to scale back its monetary stimulus. The market reaction was quick, violent and indiscriminate.

Currencies tumbled, borrowing costs soared, stock markets nosedived and bond sales choked up. No country proved immune from the turmoil. Several looked like they could suffer a repeat of the emerging market crises of the 1990s.

An almost palpable wave of relief washed over the developing world, therefore, when the Fed decided in September to maintain its stimulus scheme. Losses were clawed back and issuance rebounded, despite the chilling effect of the government shutdown and political wrangles over the federal budget in the US.

With the end of the year in sight, fund managers, considering what is in store for emerging markets in 2014. But there is little agreement on what lies ahead - except that it will be interesting.

Many asset managers expect the US central bank to maintain the size of its $85bn-a-month bond buying programme for this year at the very least. "The Fed clearly wants to see a stronger recovery before it cuts back on stimulus," says Ramin Toloui, global co-head of emerging markets at Pimco.

That gives countries a chance to replenish central bank reserves depleted by currency market interventions and capital outflows; take a hard look at government spending; and perhaps even push economic reforms that would make them more resilient to any renewed turmoil.

Indonesia, for example, saw its foreign currency reserves fall from $107bn in late April to $92.7bn at the end of July. But the central bank's safety funds have risen to $95.7bn by the end of September.

"It's prudent for countries to take advantage of the more benign environment and rebuild their firepower," Mr Toloui points out. In the meantime, the higher yields offered by developing country bonds have continued to tempt fund managers, and issuance has rebounded.

After collapsing in May and June, and staying sluggish over the summer, bond sales in emerging markets bounced back to $108bn in September and October according to Dealogic. Overall issuance has now gone above $440bn, bringing a record within reach. Corporate issuance has broken the previous record.

But the Fed will eventually "taper" its quantitative easing programme, a move likely to put bonds under renewed pressure.

Sergio Trigo Paz, head of emerging market debt at BlackRock, reckons the reaction will be less violent, given the time investors have had to prepare. But many are warier and predict turbulence and rising bond yields.

That will make the investment environment more challenging for asset managers and, as a result, make it tougher for countries and companies in the developing world to issue debt.

The main concern is whether larger countries fail to take advantage of the current calm. Among the most vulnerable are Turkey, Brazil, India, Indonesia and South Africa. But any country with a large current account deficit will be tested.

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Tapering constitutes a serious "technical" danger for emerging markets, but there are also deeper, more fundamental reasons why the developing world could be facing a difficult 2014. Economic growth has been slowing for several years.

The International Monetary Fund expects the developing world's output to expand by 4.5 per cent this year. That's 0.5 percentage points lower than its July forecast, and down from the 6 per cent growth predicted in April 2012.

Much will depend on China, which has been a big driver of economic expansion for emerging markets for the past decade. Beijing has acted to prop up its economy this year, and most analysts expect it to attain or exceed its 7.5 per cent growth target this year. But next year is more uncertain.

"China is stabilising, but we think we'll get more negative newsflow next year. And that's not good for emerging market fundamentals," says Mr Trigo Paz.

But timing a more defensive stance is the tricky part for fund managers.

"No one wants to be the last to sell, but no one wants to be the first either," Mr Toloui observes.

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