Early August sell-off in EM debt – contagion crisis or buying opportunity?

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Extent and cause of the recent sell-off

Following a rebound in emerging market assets in July, the first 3 weeks of August saw a new wave of large drawdowns, repeating the trend seen during the second quarter of 2018. The sell-off was sparked by a number of factors, most notably the deteriorating situation in Turkey.

As the graph below highlights, the early August sell-off in emerging market (EM) debt was very steep.

Exhibit 1:  returns of selected emerging market fixed income debt sectors

Note: for the period from 01/01/2018 to 20/08/18. Source: JP Morgan, as at 20/08/2018

Turkey’s vulnerability is not entirely a surprise. Indeed, we have been cautious on Turkey for quite a while given the deteriorating fundamentals there (severe external debt balances with high reliance on foreign portfolio flows to fuel economic growth; significant inflationary pressures worsened by a depreciating currency; poor central bank reaction function and governance issues around government involvement; high private sector debt…. the list goes on).

The latest development was the US imposing sanctions on Turkey, which came amid concerns about the detention of an American pastor who has been held by the Turkish authorities since 2016. This escalation with the US has only exacerbated the situation in Turkey, leading to a significant drop in the currency and a sell-off of Turkish fixed income and equity assets. Most recently, the Turkish authorities’ unresponsiveness to the snowballing crisis has compounded investor fears.

Geopolitical tensions beyond Turkey have also fuelled the sell-off. Russia has been subjected to further US sanctions sparking market speculation over additional potential US measures, including a blanket prohibition on new sovereign bond purchases.

Furthermore, other EM countries with debt vulnerabilities, poor current account metrics, inflationary concerns and heightened political risks have also come under pressure, particularly in terms of their currencies.

The following graph highlights some of the emerging markets whose fixed-income assets have sold off materially in August.

Exhibit 2:  early August sell-off – returns (%) of emerging market local currencies

Note: For the period 1 – 20/8/2018. Source: JP Morgan,  as at 20/08/2018

Contagion fears?

The sell-off in EM debt and local currencies between 1-20 August was extremely pronounced. For context, month to date, ending 20 August, the JP Morgan 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 spreads have also sold off, a rally in US Treasuries means the overall profile of returns has been less volatile. For context, the JP Morgan EMBI Global Diversified Index fell by 1.9% month to date (to 20 August).

Asian complex resists sell-off

Furthermore, as our colleagues have noted, the Asian complex has remained relatively resilient in the face of the recent sell-off. For context, the hard currency Asian fixed-income market, as measured by the JPM JACI index, is actually up 0.2% month to date (through August 20). In addition, Asian local rates and currency markets have also been relatively more stable than their global peers. This can at least partly be explained by China’s recent easing policy measures as well as better sovereign credit fundamentals across Asian markets.

No resolution to Turkish situation in sight

Specifically on Turkey, at the time of writing there has been no clear resolution of the situation. The Turkish central bank has proposed some initial measures, including reducing banks’ reserve requirements to enhance liquidity. The banking regulator also announced limits on local banks’ FX swap transactions to restrict speculation on shorting the currency. Finally, the central bank pledged to undertake all necessary measures to maintain financial stability.

While these steps have briefly provided some respite for the Turkish 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.

Even though the situation in Turkey remains precarious and shorter-term market sentiment remains challenging, we do not expect the current situation to develop into a prolonged period of contagion for emerging markets for the following principal reasons:

  1. Valuations across the EM fixed income (EMFI) asset class are extremely compelling and much of the bad news is already priced into asset values. This was not true six months ago.
  2. Technicals in EMFI are much cleaner now given 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.
  3. Global growth and company earnings have remained relatively resilient in the face of 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.
  4. China’s recent policy shift towards easing is a significant change of direction and should help provide market liquidity.
  5. Our concerns about rising US yields as a threat to EMs earlier this year have peaked, and we now see the US cycle slowing with still-benign inflation and potential for a pause in the Federal Reserve’s (Fed) cycle of rate hikes on the horizon.

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 a resolution on both fronts by the end of the year.

Although trade frictions remain, we would note that the recent rhetoric around them 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 some sort of ‘win’ on trade. A full-blown trade war is unlikely to win over the electorate, many of whom would be hurt from export tariffs and rising import prices.

In addition, we have also seen positive talks recently between the US and Europe, including the initial decision by the US to drop its enforcing of tariffs on European automobile 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 US wage inflation data remains muted, and 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 be introduced and the full cycle of rises in official rates should be revealed. However, we see this as finally clarifying the Fed’s intentions, bringing the inevitable pause one step closer. Post-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 across emerging markets. 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.

Conclusion

In summary, taking into account the positive and negative scenarios, we believe there is currently a compelling buying opportunity for emerging market fixed income assets, given the considerable value on offer for the asset class.

The EM macroeconomic backdrop remains positive for asset prices: EM growth has stabilised at an impressive pace, average corporate earnings are 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 will eventually come from the Fed, but we encourage investors to enter now because when the Fed signal does arrive it may be too late to catch the market rebound.


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L. Bryan Carter

Head of Emerging Markets Fixed Income

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