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 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, a great number of EMs appear increasingly robust.
- Inflation is structurally low in most big EMs; current account balances have improved.
- Growth has improved in Brazil, Russia and India.
- Governance has improved in South Africa, Malaysia and Chile.
- 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.
Other EM countries with debt vulnerabilities, poor current account metrics, inflationary concerns and heightened political risks came under pressure, particularly their currencies. Exhibit 1 highlights the returns of selected EM currencies relative to the US dollar in 2018 (through October).
Exhibit 1: Performance of EM currencies relative to the US dollar (2018 to mid-Nov, in %)
Source: Bloomberg, BNP Paribas Asset Management, as at 31/10/2018
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 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. Argentina’s liabilities in pesos, which were as high as 11%-12% of GDP when the currency crisis began and which were one of the main investor concerns, have now more than halved, 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 inflation.
The risk is, however, that the high interest rates the central bank is employing to squeeze liquidity 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.
- Technicals in EMFI are much cleaner now.
- Global growth and company earnings have held up in the face of the global trade frictions.
- China’s policy shift towards easing should help provide market liquidity.
- We see US growth slowing with potential for a pause in the Fed’s cycle of rate rises.
Key challenges remain
To be certain, the two key challenges that remain for the asset class are global trade frictions and further rises in US interest rates. We see these as largely priced in by the market now, with scope for resolution on both fronts.
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.
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