Following a rebound in emerging market (EM) assets in July, the first three weeks of August saw a new wave of large drawdowns, repeating the trend seen in the second quarter of 2018. The sell-off was sparked by a number of factors, most notably the deteriorating economic situation in Turkey.
Extent and cause of the recent sell-off
As the exhibit below highlights, the plunge in EM debt was steep.
Exhibit 1: Returns of selected emerging market fixed-income debt sectors from 01/01/2018 to 20/08/2018
Source: JPMorgan, as at 20/08/2018
Turkey’s vulnerability is not entirely a surprise. Indeed, we have been cautious on Turkey for a while given the deteriorating fundamentals:
- severe external debt balances with a high reliance on foreign portfolio flows to fuel economic growth
- significant inflationary pressures worsened by a depreciating currency
- a poor central bank reaction function and governance issues around government involvement
- high private-sector debt… the list goes on.
The latest factor in the downturn was the US imposing sanctions over the detention of an American pastor held by Turkish authorities since 2016. This led to a significant drop in the lira and a sell-off of Turkish fixed income and equities. The authorities’ unresponsiveness to the snowballing crisis has compounded investor fears.
Geopolitical tensions beyond Turkey also fuelled the sell-off. Russia has been subjected to further US sanctions, sparking market speculation over additional US measures including a blanket ban on new sovereign bond purchases. Assets in other EM countries with debt vulnerabilities, poor current account metrics, inflationary concerns and heightened political risks have come under pressure, particularly their currencies.
This exhibit highlights some of the emerging markets whose fixed-income assets sold off materially.
Exhibit 2: Returns (%) of emerging market local currencies from 01/08/2018 to 20/08/2018
Source: JPMorgan, as at 20/08/2018
As said, the sell-off in EM debt and local currencies was extremely pronounced. In the month to 20 August, the JPMorgan GBI EM Global Diversified index (in USD unhedged terms) fell by 5%, with most of the drop occurring over just three trading days.
While hard currency EM debt also sold off, a rally in US Treasuries meant the overall profile of returns was less volatile: the JPMorgan EMBI Global Diversified index fell by 1.9% in the month to 20 August.
Asian complex resists sell-off
Asian markets remained relatively resilient. The hard currency Asian fixed-income market, as measured by the JPM JACI index, was actually up by 0.2% in the month to 20 August. Asian local rates and currency markets were relatively more stable than their global peers. This can be explained at least partly by China’s recent policy easing measures as well as better sovereign credit fundamentals across many Asian markets.
No resolution to Turkish situation in sight
Specifically on Turkey, at the time of writing, there was no clear resolution of the situation. The Turkish central bank has proposed initial measures, including reducing banks’ reserve requirements to enhance liquidity. The banking regulator also announced limits on local banks’ currency swap transactions to restrict speculation on shorting the currency. Finally, the central bank pledged to undertake all the necessary measures to maintain financial stability.
While these steps briefly provided respite for the lira, longer-term issues around Turkey’s economic fundamentals and the central bank policies needed to address these concerns remain unresolved. The market is likely to expect more concrete measures if it is to support a more sustainable recovery in Turkish assets. The traditional crisis backstops – fiscal adjustment, monetary tightening and IMF involvement – appear to be off the table for the authorities.
Prolonged contagion unlikely
Even though the situation in Turkey remains precarious and shorter-term market sentiment remains challenging, we do not expect a prolonged period of contagion for emerging markets for these reasons:
- Valuations across the EM fixed-income (EMFI) asset class are extremely compelling and much of the bad news has already been priced into asset values. This was not the case six months ago.
- Technicals in EMFI are much cleaner after the recent outflows. Survey and listed derivatives data show that the market has swung from a short USD position in the first quarter to a clear and large long USD position, especially against EM currencies.
- Global growth and company earnings have remained relatively resilient in the face of the global trade frictions. Our real-time monitoring of EM growth in particular gives us confidence that the macroeconomic momentum has stabilised and the growth cycle for EM is still the best in almost a decade.
- China’s recent shift towards policy easing is a significant change of direction and should help provide market liquidity.
- Our concerns about rising US yields as a threat to EMs have peaked and we now see the US economic cycle slowing with still-benign inflation and the potential for a pause in the Federal Reserve’s (Fed) likely series of rate rises.
What is next? Trade tensions and the outlook for US rates
To be certain, the two key challenges remain for EMFI: global trade frictions and further increases in US interest rates. Yet we see these as largely priced in by the market now, with scope for a resolution on both fronts by the end of the year.
Although trade frictions remain, we would note that the recent rhetoric has appeared to soften, particularly on China’s side. With the US mid-term elections approaching in November, in what is largely being viewed as a referendum on Donald Trump’s political prospects, we believe it will be important for the US government to achieve a ‘win’ on trade. A fully blown trade war is unlikely to win over the electorate since many voters would be hurt by export tariffs and rising import prices.
In addition, we have seen positive talks recently between the US and Europe, including the initial decision by the US to drop its enforcement of tariffs on European car imports, as well as on NAFTA and specifically the dialogue with the incoming Mexican administration.
With regards to US interest rates, we note that recent wage inflation has remained muted. Inflation is still proving slow to materialise. The September meeting of the Federal Open Market Committee (FOMC) could send a negative signal to the market given that a new 12-month forecast will likely be introduced and the full cycle of official rate rises should be revealed.
However, we see this as finally clarifying the Fed’s intentions, bringing the inevitable pause in policy tightening one step closer. After September, this discussion may well take centre stage. It is pleasing to note that various emerging market central banks have already acted on recent actual and expected Fed rate increases to protect their currencies or stem inflation and capital outflow concerns. In this respect, Turkey is the exception to the rule.
As such, many emerging market economies are in a much better position to tackle rising interest rates today than they were, for example, during the taper tantrum period in 2013.
Taking into account the positive and negative scenarios, we believe there is currently a compelling buying opportunity for EM fixed income given the considerable value on offer.
The EM macroeconomic backdrop remains positive for asset prices: EM growth has stabilised at an impressive pace, average corporate earnings look healthy, valuations have cheapened, external vulnerabilities are broadly contained and, globally, central banks are likely to remove monetary policy accommodation very cautiously, with China embarking on more fiscal easing measures as well.
The final green light should eventually come from the Fed, but we encourage investors to enter the asset class now because when the Fed signal does arrive, it may be too late to catch the market rebound.