An uncertain period for emerging markets

“A resumption of construction work for the East Coast Rail Link, Light Rail Transit 3 and other mega projects should pull productivity growth back up, starting from the third quarter this year,’’ said Pong Teng Siew, head of research, Inter-Pacific Securities.

A period of uncertainty has fallen on emerging markets (EMs) in the wake of less than dovish comments among Federal Reserve officials.

Contrary to expectations for a further pause and a later cut in interest rates, the latest Fed minutes showed possible rate hikes later this year if the US economy remains in good shape.

EMs, which were battered last year on aggressively rising US rates, had rallied following the surprise decision by the Fed in January to be patient in its rate hike path.

There were plans for further US rate increases to hit a neutral rate that neither stimulates or slows down the economy.

But slowing growth, especially in China and Europe, trade tensions, weakening US data and the fading effects from last year’s tax cuts present mounting risks to the US economy.

Yet there are Fed policymakers who insisted that the US economy is still doing well.

That leaves EMs having to be patient and careful, in waiting for the Fed do the “right thing,” while weaker US data keeps showing up.

This wait-and-see attitude indicates that the Fed is at an inflexion point, possibly pausing further on rate hikes but not yet ready to cut rates.

Still, US central bank’s less than dovish stance underscores its wariness on the risks ahead while inflation remains manageable.

At the same time, the Fed wants to prolong the US economic expansion for which the bloom appears to have gone off.

The slowdown in business spending, which had been evident for some time, saw new orders for US-made capital goods unexpectedly falling 0.7% in December as demand declined for machinery and primary metals.

Factory activity in the mid-Atlantic region also declined for the first time since May 2016, with the index dropping unexpectedly to minus 4.1 in February from 17.0 in January.

US home resales fell 1.2% in January to a new low since November 2015.

Earlier, US retail sales registered the biggest drop since 2009, while industrial production fell 0.6% in January, the first drop in eight months, against a forecast for a gain of 0.3%.

“Before it stops hiking, there could be an increase of 50 basis points in the Fed funds rate this year,” said Suhaimi Ilias, the group chief economist at Maybank Investment Bank.

It will not be surprising, though, if the Fed pauses its rate hike series earlier than expected, as inflation remains below historical trends.

Some expect the lagged effects of US rate hikes and waning effects of tax cuts to further weaken its economy in the second half.

The downward convergence of multiple yield curves showing several interest rates across different contract lengths, also hints that economic prospects are getting grimmer.

The likelihood of a drop in global interest rates next year has increased significantly.

“The Fed funds implied probability of a rate cut in January 2020 has climbed to 18%,’’ said Nor Zahidi Alias, chief economist of Malaysian Rating Agency Corp.

Uncertainty prevails over the slowing or halting of the reduction in the Fed’s balance sheet, accumulated via stimulus bond purchases following the 2008 financial crisis.

Currently buoying markets is the promise that liquidity will not likely diminish further, as the Fed minutes indicated options for “substantially slowing” the run-off in the Fed’s balance sheet “at some point over the latter half of this year.”

“It is crucial that the Fed communicates well to the market on its intention in the ongoing shrinkage of its balance sheet,’’ said Lee Heng Guie, the executive director of Socio Economic Research Center.

As the pace of the global slowdown picks up, the health of sectors that depend on ever more buoyant liquidity is clearly at risk, noted Pong Teng Siew, the head of research of Inter-Pacific Securities.

Since October 2017, the Fed has been shrinking its balance sheet with US$50bil per month currently in Treasuries and mortgage-backed securities being run off while the rest is re-invested.

The Fed’s bond portfolio has shrunk by more than US$400bil, from an outstanding US$4.5 trillion.

Another round of quantitative easing (QE) which involves buying of more bonds by the Fed, as some are already speculating, would further swell its balance sheet from around US$4 trillion.

The benefits of increasing QE are uncertain.

QE is happening, for example, in Europe and Japan.

It leads to increased money supply and lower or negative rates which may not help in the absence of demand.

Increased liquidity may not be balanced among markets with emerging markets not really benefiting as money pours into US markets.

QE causes bubbles in asset prices.

But having become dependent on Fed liquidity, markets are focused on the flexibility in its balance sheet reduction “like a laser!”

Columnist Yap Leng Kuen sees interesting developments ahead.