Markets are adjusting this week to the clues the European Central Bank (ECB) gave last week about how it will handle deflation. Although the ECB did not change policy, it did warn the market that it can get serious if need be and pull on all the monetary levers it has at hand, to keep interest rates low.
Since that meeting, investors have taken the ECB at its word and started looking for other destinations for their capital, with much of it moving back into emerging markets. Since last week’s ECB announcement, several EM currencies have appreciated by 1-2% at the expense of the euro and the U.S. dollar. Earlier this year, the big story was the demise of many EM currencies as the Fed continued to pare back its bond purchases, thus removing some of the monetary caffeine from the global financial system.
The recent success of EM currencies should not however be taken as evidence that these markets are succeeding in their economic strategy. Take Brazil, which has posted very strong currency performances lately. A couple of years ago, it embarked on a strategy of low interest rates, an intentionally weakened exchange rate, and state subsidies, to get its sputtering economy back to a 4%+ growth rate. However, Brazil is now growing at half that rate, and inflation recently came in at 6.3% for the year, forcing Brazil’s central bank to raise interest rates. In doing so, they encouraged some yield-hungry investors to shift from Europe to Brazil, prematurely strengthening the Brazilian real and choking off its export sector.
India is another example of an EM gainer, but one with more positive fundamentals. The country is doing a lot of things right, and the mood in India and among global investors has been almost giddy on the prospect of a new government after a month-long voting process, which concludes in May. The Indian rupee hit all-time lows last August, but has recovered by 12% since that time. The pressure will now be on for the new central bank governor to reign in such fast appreciation.
My View: Low interest rates in Europe appear to be here to stay for 2014. Investors, however, should be very cautious about the alternatives, particularly with emerging markets. These economies can offer great rewards, but always carry significant risks.
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