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After the storm
Emerging market debt fundamentals remain attractive after this year's pull-back.
Written by
Mary-Therese Barton, Head of Emerging Market Debt
Alper Gocer, Head of EM Local Currency Debt
For all the market turbulence they’ve suffered this year, emerging countries are in far better shape than during past crises. In many cases, economic fundamentals remain positive notwithstanding the blanket selloff. As a result, opportunities have opened up for well-informed investors.
Unlike past bouts of turbulence, this year’s slump in emerging market (EM) debt wasn’t caused by a sharp downturn in the global economy, or a generalised equity market crash or even a commodity price collapse. Instead, it was a combination of of slower-moving threats – the risks posed by an accumulation of EM corporate debt; the impact of the US strong dollar on countries with dollar debt; the steady withdrawal of global monetary stimulus worldwide and US rate rises; the repercussions of US trade wars – that gave investors the urge to take profits on 2017’s astonishingly good run.
bargain basement
Value of an unweighted basket of 31 EM currencies relative to the US dollar and standard deviations from historic trend.
Source: Pictet Asset Management, CEIC and Datastream. Unweighted 31 EM exchange rates vs US dollar. Deviation from equilibrium is based on relative prices, relative productivity and net foreign assets. Data from 01.01.1980 to 15.10.2018.
Last year’s stratospheric market rally had, in turn, been built on the back of robust economic foundations. On balance, emerging economies were less indebted, less dependent on commodities or foreign capital flows, were more geared to domestic demand and had wealthier, more productive populations than ever. But valuations for some EM asset classes - such as EM local and dollar denominated bonds - had risen too far too fast. So when US President Donald Trump started ratcheting up global trade tensions, investors began to worry not just about how EM economies might be affected by American tariffs but also about some of the more domestic threats to economic growth.
As a result, the dollar shot higher against many EM currencies.
To be sure, some of the market’s re-evaluation of EM bonds and currencies was justified. Growth expectations for emerging economies have been revised down amid trade uncertainty. Their growth premium over developed economies is no longer widening. At the same time, they are having to adjust to the steady reversal of monetary stimulus by the US Federal Reserve.
But just as the market had rallied too hard it then pulled back too much. Economic prospects may look less rosy, but they're still positive. By and large, EM economic fundamentals remain strong – government debt levels are generally low, balance of payments positions are healthy as are foreign currency reserves, while domestic demand remains robust.
An attractive premium
One key worry has been China. But Trump’s measures against the country are unlikely to trigger a collapse in global trade, not least because his decision to ramp up public spending is bound to cause the US’s current account deficit to widen further. A significant amount of US trade with China is likely to be re-routed to other competitive emerging economies.
At the same time, the renminbi’s 8 per cent depreciation against the dollar so far this year largely offsets the 10 per cent tariffs the Trump administration has imposed, leaving Chinese exporters little worse off. Our economists estimate that even a full implementation of higher tariffs on USD500 billion of its exports to the US would reduce Chinese GDP by little more than a percentage point. As the trade measures currently stand, the hit is around a quarter of a point of growth.
EM policymakers have largely responded to the turmoil with well-calibrated policies. Interest rates were increased and reinforced with fiscal adjustments. Meanwhile, flexible exchange rates have helped to absorb the shocks. As a result, most EM economies have weathered the market storm largely unscathed. Indeed, the latest set of EM leading indicators have improved on a rolling quarterly basis, and currently stand well above their three-year moving average.
The exceptions are countries with significant dollar debt and poor balance of payments positions. Turkey and Argentina have been particularly hard hit. Both have large current account deficits and a dependence on inflows of foreign capital. When investors grew worried about these imbalances, they withdrew their capital. The subsequent currency crises then caused inflation to ramp up, which forced Argentine and Turkish central banks to hike interest rates. Although the rate rises weren’t sufficient to stymie the panic, they nevertheless put a dampener on economic growth. This, in turn, fuelled the economies’ downwards spiral.
As the market rallied too hard, it then pulled back too much.
Elsewhere in the EM universe, conditions have been complicated further by a busy electoral cycle, not least in Brazil.
But none of that justifies the scale or breadth of the selloff across EM assets. The resultant repricing has opened up attractive opportunities for active managers. The currencies and bonds of strong economies with good growth prospects look cheap again – such as those of South Africa and Mexico.
More broadly, the premium offered by EM debt now looks attractive.
In the wake of the Asian crisis of the late 1990s, many governments took steps to reinforce their institutions and implement prudent, far-sighted economic policies that are now standing their countries in good stead. Most have benign inflationary environments, solid growth prospects and burgeoning middle classes, which make up an ever larger part of their electorates.
Emerging market currencies are the cheapest they’ve been relative to the dollar in at least two decades, according to our economists’ valuation metrics. EM currencies are some 20 per cent undervalued against the dollar, with the renminbi cheaper than ever on a purchasing power parity basis. Meanwhile, EM dollar bonds yield 6.4 per cent, more than double their US equivalents.
At times like this, investing takes a little courage and a lot of hard headed analysis. But the potential rewards are commensurate.
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