Confidence is slowly being restored in emerging markets after a recent steep downturn. But what are the prospects for a sustained recovery in 1999 asks Moin Siddiqi.

The volatility of international financial markets during September is subsiding and the risks of an outright recession and deflation have faded. Major institutional investors evidently think the economic storm has now passed, and there are signs of a renewed risk appetite among investors. Therefore, a meltdown in global markets as discussed in African Business, October 1998 has failed to materialise.

On the contrary, a lax US monetary policy has induced a fresh rally in global stock markets in recent weeks, and the Dow Jones - an international benchmark - is again re-testing its mid-July 1998 peak. But upside however, appears over-valued amid bearish corporate earnings. Last August and September, fund managers divested from Asia and emerging markets generally, and reinvested heavily into high-quality(OECD) government bonds. These safe assets are now expensive as long bond yields have fallen to historic lows.

Lower returns on bonds has increased the relative attraction of equities. Reasons behind the global financial crisis were a slow-down in world trade flows, a banking collapse in Asia and a credit-crunch in Japan, with potential to spill over into Europe and the US. This led to growing fears of a severe retrenchment in consumer spending in rich countries and low business confidence.

A combination of factors are underpinning the general improvement in market psychology and confidence. Centre-left governments in G-7 countries are now embracing traditional Keynesian demand management theory in order to avert a 1930-style depression. The developing world should also push for growth and jobs. There is ample scope for a huge Keynesian fiscal stimulus in most countries. A severe deterioration in real economy-production/employment, could lead to starvation in Africa and Asia, which lack the necessary social safety nets.

The return of financial stability has also been helped by recent interest rate cuts in America, Britain and Canada. Japan is at last tackling its chronic banking problems through a radical long-term restructuring costing $512bn. More importantly, the G-7 has agreed to fund new IMF/World Bank emergency credit-lines. The IMF now has $90bn to help healthy and well-managed economies that find themselves hostages of speculative currency attacks, as in the case of South African rand or Australian dollar last July. (See View from the city, AB October 1998).

Expect global interest rates to decline dramatically in 1999, led by the US Federal Reserve. The key Federal Funds rate - currently at 4.75% - is in effect the lowest level in four years. The futures markets are anticipating a further 0.75% cut in short-term rate by mid-1999 in order to underpin economic growth.

A more lax US monetary policy has lifted the gloom from emerging markets in two interrelated ways. Firstly, lower US money rates should hit the dollar, hence relieving selling pressures on respective emerging market currencies wholly or partially pegged to the greenback. This in turn should prompt falls in interest rates from Latin America to Africa and Asia. Thus, with the risk of devaluation abating, the probability of an imposition of capital controls, as happened recently in Malaysia, is also reduced.

This is good news for foreign investors in markets like South Africa, Russia and Brazil, where the risk of exchange controls is usually high. However, analysts say easy money by itself will not lead to higher growth in the OECD markets and speedy upturn in capital-starved developing nations. As Japan’s experience shows, falling interest rates on their own won’t prevent the global economy from dipping into a sharp slow-down this year. The Paris-based think tank, the OECD, expects growth of 1.7% in developed markets, down from 2.2% in 1998.

Therefore, sluggish economic activity will continue to depress commodity prices and hence the earnings capacities of South Africa, Russia and Venezuela. This indicates a bearish earnings year for most emerging market companies, as the demand for their exports in developed markets will be weak. There is a liquidity squeeze and cheap money may not lead to a vast surge in new bank lending world-wide, or higher foreign direct investment in emerging markets.

The weaker dollar is providing support for many markets, which are now relatively cheap on forward price:earnings ratio. However, without sustained improvements in economic fundamentals, it is too early to increase exposures in these markets. The best achievements for emerging markets in 1999 will be stable currencies, return to non-inflationary growth era - helped by lower interest rates and concrete progress on fiscal/financial reforms. But improvements in export-earnings will remain outside their control.