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Column : What’s next for emerging markets?

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SummaryAfter last week’s dramatic rout in global markets, investors are now facing a new, and disquieting environment in which long-held verities have been stood on their head.

After last week’s dramatic rout in global markets, investors are now facing a new, and disquieting environment in which long-held verities have been stood on their head. The so-called developed countries are acting anything but and the previously unthinkable has become commonplace. The US teetered on the brink of default in late July as its dysfunctional political process failed to find a way of putting its debt burden on a sustainable basis. And that has now prompted Standard & Poor’s downgrade the US’s once bulletproof AAA credit rating. Investors are realising that what was once considered safe is actually rather risky.

Meanwhile Europe’s sovereign debt crisis is spreading and the International Monetary Fund worries that it lacks the funds needed to help bail out Spain or Italy. All this as growth in the US and Europe is slowing. Clearly, we’re not in Kansas any more.

So is it time for investors to thrown in the towel and embrace the new world disorder? Not quite. Capitulation would imply a wholesale rush out of risk assets, including emerging markets and commodities, and into traditional safe havens, such as gold and, yes, US Treasuries (even now there really is no alternative to these for investors looking for a refuge in times of market uncertainty). While that will no doubt be the initial reaction—markets do tend to be correlated during a panic—investors will become more discriminating once the dust settles.

The reality is that the global markets are still awash in liquidity and will soon be drowning in it. The US Federal Reserve may have ended QE2, its $600-billion bond-buying programme, in June, but it is not about to withdraw that liquidity. Just the opposite. Now that fiscal stimulus is off the table, monetary authorities in developed countries will rely increasingly desperately on flooding markets with additional liquidity to try and prevent the dreaded double-dip recession. All that liquidity has to go somewhere.

Thursday’s global market rout will accelerate the reallocation of capital from stagnant and dysfunctional developed economies and into well-managed emerging markets. That process is already under way, with investors moving assets into emerging market sovereign debt. Over the last month, yields on emerging market sovereign bonds have fallen sharply by up to 75 basis points as investors seek new safe havens now that the traditional refuges are looking decidedly risky. The prices of debt from countries including Brazil, Russia and Mexico, which are perceived as

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