Much at stake for EM on jobs Friday

Reuters - Emerging markets will have a great deal at stake when Friday's U.S. jobs figures are announced.

If the data is good and a Federal Reserve taper seems more likely, emerging markets will fall, hard, while if hiring was disappointing we can count on an outsized rally.

In part, this is for no more complicated a reason than emerging markets are at the riskier end of the investment spectrum. Bond buying works by exchanging cash for 'safe' assets and forcing a new investment decision with lower returns for safety. That is intended to prompt risk-taking and the riskier an investment the more, proportionally, it benefits.

But going beyond this there are structural reasons why now may be a particularly poor time for many emerging markets to be faced with tighter global monetary conditions.

First, many, notably India and South Africa, must attract investment to make up high current account deficits. With QE on, that money flows easily, but, as we saw last summer, if a bond-buying taper is in prospect, investors will quickly do new calculations.

Secondly, a number of key emerging markets are actually showing signs of the risk of stagflation - slowing economic growth but high inflation. That's a classic recipe for misery, both in terms of the economy and for investors. Growth in Brazil, India and Russia is decelerating but inflation remains uncomfortably high. Brazil, for example, contracted by a half a percent in the third quarter but has inflation of 5.8 percent.

Combine rocky local conditions with QE and you have what we've experienced: a sell-off, a bleeding, but nothing hugely violent. Take those conditions and add in a taper and you might just get something a bit worse.

All of this is to say that emerging markets are vulnerable to the inevitable taper by the Fed. But inevitable is not the same as 'now' or even 'soon'. If the Fed carries on at the current rate it will own far too much of the bond market this time next year but it is possible that the U.S. central bank will contrive different ways to keep conditions loose.

As for tomorrow's numbers, even if they are better than expected they won't push the Fed to act before year-end. While ADP reported that private sector employment climbed by 215K in November, the best showing in a year, there are still reasonable grounds for some delay.

MAKING A CHANGE OR MARKING ONE?

The larger vulnerabilities of emerging markets are arguably structural. A Fed taper won't so much cause these issues as expose them to wider public view.

"Emerging market growth from 2000 to 2012 was atypically high and we might be back in a situation that is more reminiscent of the early 1980s. The growth of the last 12 years was neither sustainable nor likely to last," Anders Aslund, economist at the Peterson Institute, wrote in a recent paper. (http://www.iie.com/publications/wp/wp13-10.pdf)

For those of you who don't remember a time before the heyday of BRICS, the 1980s were not a kind period for emerging market growth. Interest rates were on the rise and commodity prices were falling. Both trends may well reappear and be joined by a long-running theme of re-shoring of manufacturing.

If a taper marks a turning of a longer credit cycle it will hurt emerging markets disproportionately and do the most damage to those which need the most financing.

As well, there are reasons to suspect that the next decade or so of global growth will be less resource-intensive than the ones just past. Re-shoring of manufacturing, to take advantage of new technology, of cheaper energy in the U.S., and other trends, would feed this. That re-shoring would be a double blow to emerging markets, hurting those, like Brazil, which export raw materials and those, like China, which may find their manufacturing base threatened.

An emerging market investment landscape with slower growth, worse global competition and higher interest rates might be a recipe for multi-year underperformance.

Again, none of this has to kick off on Friday, or really any time soon. A number of economists, notably Larry Summers, have argued that the U.S. itself is in a bit of a structural trap, an analysis which implies that rates need to stay low and deficits high indefinitely. And certainly incoming Fed chief Janet Yellen seems well aware of the employment part of her mandate.

Still, whether the signal for a taper comes out of tomorrow's data or waits six or eight months, the taper is likely to arrive in 2014, making it a difficult year for emerging markets. (At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. You can email him at [email protected] and find more columns at http://blogs.reuters.com/james-saft) (Editing by James Dalgleish)