At the beginning of 2018, emerging markets were in the midst of a bull run that promised to extend across the year. Positive momentum proved unsustainable as the world came to terms with trade tensions and fears of contagion from idiosyncratic risk.
In 2017, something strange was going on: after years of economic and financial woe, the global economy was actually in good shape.
“Last year, we were in the unusual position of experiencing synchronised global growth,” said Sergi Lanau, deputy chief economist at the Institute of International Finance.
Economic growth was moving ahead nicely in the United States, European activity was picking up and the economies in the emerging markets were recovering. The good news had reawakened latent investor demand for exposure to developing economies.
“The markets were in an envious position at the end of 2017,” said Gregory Smith, fixed income strategist at Renaissance Capital. “Inflows into emerging markets had been fantastic over the year as the US dollar softened. The atmosphere for the global economy had turned around and sentiment towards emerging markets was positive.”
Hopes were high that emerging markets would recoup much of the weakness endured since the financial crisis. High enough for investment management group Ashmore to forecast in a research note that “2018 [was] to be one of the strongest years of inflows to emerging markets for some time”, and proclaim that over the period 2017 to 2021 “between currency and yield, we expect emerging markets local markets to give 50% returns in US dollar terms”.
“For government bond markets of four-and-a-half-year duration, that’s pretty impressive,” said Jan Dehn, head of research at Ashmore.
Hiking for health
“We started to see a recovery in emerging markets at the end of 2015 with the hike by the Federal Reserve,” said Dehn. “Prior to that, emerging markets looked like they’d priced in the end of the world, with local markets trading commensurate with a Fed funds rate of 5.75%.”
In December 2015, the Federal Reserve raised rates for the first time in seven years, from a record low of 0.25% to 0.5%.
That hike was the first sign that the prolonged period of all-but-free money and quantitative easing in the developed world was coming to an end. Since the 2008 financial crash, interest rates had been steadfast at record lows, while central banks had pumped huge amounts of cash into the financial system in an attempt to kick-start the global economy and spark modest levels of inflation.
The side effect of those policies, however, had been to suck funds into the stock and bond markets of the developed world and out of emerging markets.
“It was a huge distortion,” said Dehn. And a one-way bet for investors.
Unwind and stretch
As the distortion moved into a correction phase, the US dollar weakened and money returned to EM in search of returns. Fund flows continued to favour the asset class into 2018, but momentum ran out of steam after a few months. Perhaps it was only to be expected after such an impressive performance.
“Synchronised global growth is so unusual that is was bound to end at some point,” said Lanau.
It was just a question of when the end would come, by how much markets would move and whether it was a correction to the trend or the start of something new.
“We’ve recovered over half the losses in emerging markets in the last two years, so a pull-back in prices is acceptable,” said Dehn.
Regis Chatellier, emerging market senior credit strategist at Societe General agreed. “We were expecting a repricing in the emerging markets at some point this year, as they were already looking a bit tight,” he said shortly after the US had implemented trade sanctions on Turkey for the arrest of an American pastor. “I was a bit surprised by the magnitude, however.”
Problems in Turkey were the latest of a number of hurdles that EM had to overcome in 2018, not least the behaviour of the dollar. In April, there was a sharp retrenchment in emerging market portfolio flows as the dollar started to strengthen.
“From the last week in April, we started to see steady outflows,” said RenCap’s Smith. “There have only been a few weeks of inflows since then.”
Sparking dollar strength was a sell-off in US bonds that saw the 10-year Treasury yield hit 3%. For the first time in almost three years, investors could earn reasonable and secure returns from government bonds by holding dollars.
Further support for the dollar came from new Fed Chairman Jerome Powell’s hawkish stance on monetary policy, which held the promise of more rate rises in the face of bumper US growth (Q2 increase of 4.1%), from deteriorating growth expectations for the European Union (thought likely to prolong the ECB’s dovish approach) and from the Trump effect.
The imposition of US tariffs on Chinese goods, as well as sanctions imposed on countries elsewhere, reinforced the attraction of holding dollars while damaging the outlook for the global economy. Emerging markets were wobbling.
Trouble at home
Dollar strength and anxiety over global trade may have given investors the opportunity to take profits but domestic issues in the likes of Turkey served as a reminder that emerging markets are a volatile asset class.
“Each year, we’re likely to see one of the emerging market countries screw up,” said Dehn. “And it’s usually self-inflicted.”
Dehn’s axiom proved true on a number of occasions in 2018, but perhaps most significantly in the case of Turkey when the US imposition of tariffs in August prompted a precipitous fall in the value of the Turkish lira. Days into the crisis, the lira hit a low of 7.24 to the dollar from a peak of 3.40 in September of 2017.
This prompted fears of contagion, particularly in those countries heavily indebted to the international markets. The South African rand and Argentine peso, which was already under pressure from its own domestic problems, also came under attack.
“While problems in the likes of Turkey and Argentina, which have borrowed extensively in the international markets, are not hugely significant on the global stage, it does act as a signal,” said Lanau. “They may not have a direct link to other emerging markets, but they do affect sentiment.”
Timing was also relevant.
“While some of the other emerging market risks this year, such as Venezuela’s default, were well flagged and specific, the contagion factor with Turkey is higher,” said Chatellier. “The risk was not adequately priced in, liquidity in the markets over the summer is notoriously poor and we’ve not had any significant inflows into emerging market funds for some time. There’s just been no really good news on emerging markets for a while.”
Nevertheless, there is fundamental cause for optimism.
“There is room for manoeuvre,” said Chatellier. “The rest of the emerging markets look in relatively good shape. Economies have been growing, current account deficits are moderate, FX reserves have risen and inflation in the most part is of little concern. I don’t see any risk of any default in the short term for Turkey.”
Election correction
Despite longer-term fundamental support, there could be more trouble in store for emerging markets in the near future. The Brazilian election, for one, is cause for concern, especially in the minds of investors prone to react to headlines.
“There has been a switch in bullishness from retail in particular,” said Smith. “Sentiment has shifted from ‘fantastic’ to one of caution.”
But perhaps the biggest obstacle to overcome stems from the US.
“The last remaining unresolved risk revolves around President Trump’s trade war,” said Dehn, “Until some other issue emerges, of course.”
The trade dispute between the US and China is important for all emerging market countries.
“Ongoing uncertainty about the ultimate scope and level of tariffs or other restrictions to trade and investment are contributing to lower capital inflows in emerging markets in general,” said Marie Diron, managing director of sovereign risk at Moody’s.
It makes the outcome of the upcoming mid-term elections in November significant as it could affect the enthusiasm for further trade tensions.
“There was a strong bounce in emerging market prices in July, when Trump backed away from threats of tariffs against Europe,” said Dehn.
“We could see the China-bashing continue up until the elections,’” he said. “It’s difficult to see how far the trade war with China will go, but as soon as it starts hurting US companies, then Congress will step in to correct it.”
That view is dependent on whether Trump continues to pursue the agenda on which he was elected or adopt a more pragmatic approach to international relations.
“We assume that the trade dispute will persist for some time,” said Diron.
It suggests that volatility in the emerging markets is here to stay, at least for now.
“Even though we can’t see a major crisis at the moment, we expect spreads to stay wider than the long-term average for the rest of the year,” said Chatellier.
Longer term, the asset class is still thought a good investment.
“We tend to think that there is room for growth in the emerging markets,” said Smith. “It’s just that the magnitudes have changed and that recent news has reinforced more than ever the need to differentiate.”
Others are sure that recent volatility is just a temporary blip in the outlook for EM and that any subsequent weakness represents a great opportunity to add exposure. Nevertheless, price action in 2018 is a wake-up call to investors and reinforces the need to be selective and vigilant when addressing the asset class.
“We’re very, very bullish for emerging markets next year,” said Dehn. “Investors are underweight and institutional money continues to come into the market. But even if the market sentiment is positive, there’s always the need for due diligence and active management. After all, anyone underweight Turkey recently will have substantially beaten a passive fund’s performance.”
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