We have long argued that there is a real reason to worry about the fundamentals of many emerging markets (EM): too many countries have recklessly racked up debt in the low-interest rate environment of the past few years with economic policies that have not warranted such accelerated borrowing. Equally, the proceeds have not always been invested productively. However, we must stress that this does not relate to all EMs. A duality has emerged, with a small, but growing number of EMs now at real risk of imminent debt distress. We have already witnessed a pickup in default rates and we expect that increase to gain pace as US interest rates continue to rise.
On the other side of the duality, however, a great number of EMs appear increasingly robust. Inflation is structurally low in most big EMs and current account balances are better across the board. Growth has improved in Brazil, Russia and India. Governance has improved in South Africa, Malaysia and Chile. Indeed, the adherence to economic orthodoxy and the liberal global economic order is currently stronger in China and eastern Europe than it is in the US and UK.
We believe the 2018 correction in EM asset prices exposed the value on offer in this asset class, particularly among the strong performers. Globally, central banks are still likely to remove monetary policy accommodation cautiously, with China embarking on fiscal easing measures to ensure a soft landing. Furthermore, the long-running trade disputes appear to be near resolution, in our view.
The impact of rising US interest rates on large borrowing programmes in US dollars was felt most directly in Argentina and Turkey. The knock-on effect shook investor confidence in the broader asset class over the summer of 2018 and led to modest outflows from EM debt funds, triggering limited contagion in countries with similar fundamentals or close trade relationships (see exhibit 1).
Exhibit 1: Returns of selected emerging market fixed-income debt sectors
Turkey’s vulnerability was not entirely a surprise given the poor fundamentals: high external debt balances with major reliance on foreign funds to fuel economic growth; significant inflationary pressure worsened by a depreciating currency; a poor central bank reaction function and issues around government involvement.
This was compounded by the US imposing sanctions over Turkey’s detention of a US pastor. Turkey’s currency, bonds and shares experienced a sharp sell-off. That eventually forced the central bank to raise interest rates. For the moment, this has staved off a further exodus of investment.
Other EM countries with debt vulnerabilities, poor current account metrics, inflationary concerns and heightened political risks came under pressure, particularly their currencies. Exhibit 2 highlights the returns of selected EM currencies relative to the US dollar in 2018 (through October).
Exhibit 2: Performance of EM currencies relative to the US dollar through October 2018 (year-to-date, in %)
Asian bonds were relatively resilient. The hard currency fixed-income market, as measured by the JPM JACI index lost only 2.43% in the year to date (30 October). Asian local rates and currency markets were also relatively more stable than their global peers. This can at least partly be explained by China’s policy easing measures as well as better sovereign credit fundamentals across Asian markets.
Among the crisis countries, we are perhaps most positive on Argentina. The peso gained more than 10% since a monetary policy programme backed by the IMF was put in place when Guido Sandleris took over as governor of the central bank in September. Argentina’s liabilities in pesos, which were as high as 11%-12% of GDP when the currency crisis began in April and which were one of the main investor concerns, have now more than halved (to 5%-6% of GDP), helped by the devaluation of the peso.
Argentina is also arguably in a stronger position now thanks to its plan to freeze money supply growth for the next nine months as it attempts to lower a monthly inflation rate that was running at 6.5% in September.
The risk is, however, that the high interest rates the central bank is employing in this liquidity squeeze strangle economic growth just as Mauricio Macri campaigns to be re-elected as president in 2019.
Given our view that more EM counties will experience Argentina and Turkey type crises over the next few years, how can we be so sanguine on the asset class? In summary, we do not expect a generalised contagion of emerging markets for the following principal reasons:
- Valuations across the EM fixed-income asset class are extremely compelling and asset values already reflect a higher incidence of default and volatility. This was not true six months ago.
- Technicals in EMFI are much cleaner now after the recent outflows. Survey and listed derivatives data show that the market swung from a short USD position in the first quarter of 2018 to a clear and large long USD position, especially against EM currencies. Dedicated managers are underweight EM currency and are under-leveraged in their investments.
- Global growth and company earnings have remained relatively resilient in the face of the global trade frictions. Our real-time monitoring of emerging markets gives us confidence that growth has stabilised and the cycle for EM is still the best in almost a decade.
- China’s policy shift towards 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 potential for a pause in the Federal Reserve’s (Fed) cycle of rate rises.
Key challenges remain
To be certain, the two key challenges that remain for the EMFI asset class are global trade frictions and further rises in US interest rates. Yet we see these as largely priced in by the market now, with scope for resolution on both fronts.
On the trade frictions, we would note that the rhetoric around them has appeared to soften, particularly on China’s side. In the US, a full-blown trade war is unlikely to win over the electorate, many of whom would be hurt by export tariffs and rising import prices. We have seen positive talks on trade between the US and Europe, as well as on NAFTA.
With regards to US interest rates, US wage inflation data has remained muted. Equity market volatility suggests the tariffs imposed by the US on China are weighing on business sentiment. In our view, this increases the probability of a pause in the Fed’s drive to push official rates higher.
It is pleasing to note that various emerging market central banks have acted on actual and expected Fed rate increases to protect their currencies or stem inflation and capital outflow concerns. As such, many EM economies are in a much better position to tackle rising rates than they were, for example, during the taper tantrum period in 2013.
The green light for further gains may eventually come from the Fed, but we encourage investors to enter this under-owned asset class now because if and when the Fed signal does arrive, it may be too late to catch the market rebound.
We believe that, encouragingly, the good EM stories comprise the majority of the main benchmark’s market capitalisation.
Separating wheat from chaff
We believe that sustainability lies at the heart of responsible long-term investing. As such, we have developed a proprietary ESG implementation for our EM investments that reflects the duality in EM policies and eventual outcomes. Our methodology tilts in favour of high-scoring countries, while limiting the exposure to the worst performers in terms of long-term climate, social policy and institutional factors.
We believe this approach, in addition to our alpha-generation skills and smart-beta benchmark replication, comprises the essential steps in protecting investors and ensuring favourable returns.