Singapore: Judging by the strength of the relief rally seen after the US Federal Reserve did nothing last week, some Asian emerging markets could be far more vulnerable than earlier thought when the Fed finally does decide to slow its dollar printing presses.
"I anticipate more volatility in the markets linked to policy action out of the US", said James Thom, investment manager for Aberdeen Asset Management, Asia Pacific equity portfolio. "When tapering does finally come through we're likely to see more turbulence and probably a negative reaction in Asian markets and Southeast Asian markets in particular."
Investors had become sanguine about the risks associated with the Fed reducing its USD 85-billion-a-month bond-buying programme, since US officials first flagged in May that they could start tapering this year.
That sparked a heavy sell-off in Asian currencies and stocks that gave investors reason to believe that the impact of tapering was largely priced into markets.
Markets recovering from June lows and their relative stability in the run-up to last week's Fed meeting, at which the US central bank had been expected to announce it was winding down its easy money policies, reinforced that view.
But the strength of the rally - in developed and emerging markets alike - that followed the Fed's surprise decision to wait a while longer showed some markets were far more sensitive to tapering than had been appreciated.
"Markets in those countries that were hit hardest during the summer sell-off have rallied most since the Fed meeting," Capital Economics wrote in a research report. "The Indonesian rupiah, Turkish lira, Brazilian real and Indian rupee have all gained around 3 percent against the dollar."
Handicapped by big current account deficits, countries such as Indonesia and India had been hit so hard in recent months that many investors stopped worrying about tapering risks and focused on their economic problems instead. But the scale of their rally after the Fed's decision to stand pat revealed just how big an issue tapering still is for them.
"The upside volatility was huge. Markets across the board jumped and the more battered the market the bigger the jump," said one long-only portfolio manager in Singapore.
Jakarta stocks, for example, at one point leapt more than 7 percent in reaction to the Fed's non-move, he noted, although Indonesia's economic problems were the same. The only thing that changed was the tapering outlook.
"When the Fed tapers later in the year there'll be even greater downside volatility. More than we thought," the portfolio manager said.
MORE TO COME
Just why investors had become over-sanguine about the risks attached to tapering is unclear.
After all, despite a sell-off over the past few months that took bourses and currencies to multi-year lows and bond yields to multi-year highs, not much of the money that flowed into Asia since the Fed began its bond buying programme in late 2008 has actually left the region.
Now, there is a growing realisation of the risk that this vast amount of funds could pour out, and investors are eyeing US data nervously for stronger evidence of an economic recovery that could tip the Fed's hand.
"Tapering concerns are not over," said Chang Chiou Yi, regional strategist (ASEAN) at CIMB Research, adding that the big exporting economies of North Asia would fare better than those economies in Southeast Asia that are less export-focused.
Chang said government and central banks that had taken the precaution of securing currency swap agreements and raising interest rates had, at least, offset some of the downside risk.
Aberdeen's Thom agreed that Southeast Asian markets were more vulnerable. "Partly this is because Southeast Asian markets have been amongst the better performers and so they're a natural source of profits for foreign investors. In that sense these markets are victims of their own success," he said.
"The second point to make though is that these markets are relatively illiquid and shallow, so when sentiment does change it tends to have an exaggerated impact as everyone is rushing for the door, and it's just a small door, all at the same time. You see this particularly in markets like Indonesia and the Philippines."
Asian markets have already surrendered most of the gains made since the Fed's decision, suggesting the euphoria is over and that investors are now making a more sober assessment of tapering risks.