Morgan Stanley Explains The Two Simple Reasons Emerging Markets Are Getting Crushed

By: JOE WEISENTHAL

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Morgan Stanley has a new big report on emerging markets (which have been getting hammered lately) titled: “What If The Tide Goes Out?” asking how bad things could get for these markets, and which ones are most exposed to the downside.

The “tide” is a useful image here for analysts. After the crisis, as the US and other developed markets eased, a huge wall of liquidity rushed forth, looking for higher yields, and attractive investments abroad.

Now with rates rising in the developed world, and seemingly better investment opportunities back home, it may be time for the tide to go back out, leaving the developing world parched.

The paper is deep, and we’ll probably be drawing on it in future posts, but one paragraph really explains the unique situation for emerging markets right now.

Our long-held view has been that we should expect a strong structural drag on EM growth. The combination of a structural drag and a deteriorating risk-reward from using cyclical policy tools has generated a weak recovery. On the other side of the economic globe, the Fed’s assessment of when to taper its asset purchases, end them, and finally start to end monetary accommodation is best viewed as an exogenous tightening of EM policy. Indeed, the volatility following the Fed’s move to a data-dependent path for tapering has acted as a wake-up call to investors to assess these risks.

There you have it. Structural weakness in many of these markets (some of it owing to maturity) combined with Fed tightening, and bam, the massive tide begins going the other way.

That wave isn’t just a dramatic image (although that’s nice).

It represents a popular metaphor to explain what’s happening in markets.

After the Fed launched Quantitative Easing post-crisis, there was a huge liquidity wave that rushed towards emerging markets in search of higher yields.

Now the view is that the tide is coming out, and the water is rushing in other directions. The liquidity is coming back to developed markets, leaving emerging markets increasingly parched (hence the decline in emerging market assets lately).

The situation can be explained in two charts.

The first chart is real interest rates in the United States, which have been surging lately.

real rates largeFRED

Higher real interest rates are appealing to investors, because it implies a higher ability to get a return in said economy and/or currency. Suddenly US assets are appealing because of these higher real interest rates.

And emerging markets?

James von Simson posted this chart showing the huge outflows from emerging market funds last week.

The worst outflows in years. The water is rushing in the other direction.

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Read more: http://www.businessinsider.com/in-2-charts-youll-understand-the-gigantic-shifting-tide-thats-reshaping-global-markets-2013-6#ixzz2WCAFs9VG

Read more: http://www.businessinsider.com/morgan-stanley-explains-the-two-simple-reasons-emerging-markets-are-getting-crushed-2013-6#ixzz2WC1lIoTM

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