Author: NN Investment Partners
Emerging market (EM) assets have been resilient in the past two years due to improving domestic demand growth, benign inflation and a weaker US dollar. Yet, the combination of a steady repricing of Fed expectations, rising US bond yields, climbing oil prices and renewed dollar strength has led to a more challenging environment in the past few months.
Some stabilisation in the oil price and in the dollar would alleviate much of the pressure. We hold on to our overweight positions in EM equities and EM local currency bonds.
Challenging environment for emerging market debt
The pressure on EM assets has increased in the past few months. A positioning squeeze in EM debt, triggered by the combination of a rising oil price, steady re-pricing of Fed rate expectations and a strengthening US dollar, has led to a widening in hard-currency spreads of around 80 basis points and a 7% depreciation of EM currencies since the beginning of February. Most selling pressure has materialized since the end of April, when the US dollar appreciated sharply. The stronger dollar, coupled with the steady rise in the oil price, justifies a more critical look at the EM inflation picture. Benign inflation, moving in a tight range of 3%-4% in the past four years, was the primary factor that helped boost investor risk appetite for EM. Strong inflows strengthened EM currencies and enabled central banks to meet inflation targets while reducing interest rates.
This virtuous cycle has been interrupted, first by the sharp increase in the oil price and later by the appreciating US dollar. Higher oil prices result in higher energy costs or in larger fiscal deficits if fuel subsidies are in place. Higher oil prices also have a second-round effect on food prices, which in emerging markets represent a relatively large weight in the consumer prices index (CPI) basket. This is why substantial oil price increases usually have a big impact on EM inflation expectations. The strengthening dollar of the past few weeks has made this impact even larger, as a stronger dollar increases the local-currency costs of energy and other imports even more.
So, the deteriorating EM inflation outlook explains most of the recent selling pressure in EMD. Whether the pressure will intensify or soften will largely depend on the oil price and the dollar. With EM growth dynamics of the past years having been positive but never excessively so, we do not see a good endogenous justification for worsening EM inflation. But as long as the global environment stays as it is, with rising oil, steady Fed re-pricing and an appreciating dollar, outflows from EMD are likely to continue. We do however believe that the recent dollar appreciation is nothing more than a position adjustment. Net short USD futures positions by speculators reached quite stretched levels on 17 April. The dollar’s gain since then has coincided with a reduction of these dollar shorts.
EM equities have started to underperform DM equities
This introduction about inflation and EMD helps explain the recent moves in EM equity markets. Since their 22 March peak, EM equities underperformed developed markets (DM) by 6 percentage points. This is substantial, but not enough to break the positive trend that started more than two years ago (see chart).
EM equities are feeling the deteriorating EM inflation outlook and the position unwinding in EMD that is leading to depreciating currencies and rising yields. The effects are direct, through currency weakness that pushes the dollar value of the category down, as well as indirect, through higher discount rates and an adjustment in growth expectations. The main reasons why the EM equity correction has been modest so far are the positive economic and earnings growth momentum and the resilience of China, India, Korea and Russia, which together represent more than half of the EM equity universe.
Tighter financial conditions pose a risk to EM growth
Thanks to the steady recovery in EM credit growth, from 6% in the first quarter of 2017 to 10% today, which is pushing domestic EM demand growth higher, and the still-strong global demand that has kept EM export growth in double digits, EM growth continues to be in its tight 4.5%-5.5% range. With Chinese growth gradually slowing, this implies that EM growth momentum ex-China is positive.
So while the global environment for emerging markets has become more challenging, the starting point of EM growth remains positive. A turnaround would require a large and lengthy tightening of financial conditions.
Our proprietary EM financial conditions indicator, which captures changes in policy rates, interest rate expectations, fiscal policy, exchange rates and foreign capital flows for the whole EM universe, was positive for most of the past two years. Since April it has come down and last week it turned negative. A continuous deterioration could stop the credit growth recovery in emerging markets, with negative implications for future consumption and fixed investment growth throughout the emerging world. For now, we feel it is too early to call the end of the EM credit recovery.
Market focuses on Argentina, Turkey and Indonesia
Meanwhile, the relative strength of China, India, Korea and Russia in this environment is encouraging. These markets should help to keep the EM-DM outperformance trend in equity markets intact.
Most attention is currently focused on three countries: Argentina, Turkey and Indonesia. Due to large macro imbalances and/or concerns about policy makers’ moving to a more unorthodox policy path, their central banks have come under severe pressure.
In Argentina, where the pressure has been highest, the authorities reacted with three emergency rate hikes of 13 percentage points in total and – very important – with additional fiscal tightening. This is crucial because the slow fiscal adjustment of the past years failed to materially reduce inflation, as the authorities kept on printing money to finance the deficit. Hopefully the credibility of the Argentine government and the high interest rates will prove good enough to stabilise the peso. This is crucial, because with a sharper depreciation the inflation rate will spike to levels very difficult to control. The solution to Argentina’s vulnerability lies in fiscal reform. We consider it positive that the authorities came with additional tightening when the pressure mounted. Another positive sign is that the important capital market reform will be approved earlier than anticipated. And finally, the government has announced that it is negotiating with the IMF to obtain credit support. The prospects of an IMF package with policy conditionality should help to regain confidence as well.
In Turkey and Indonesia, the central banks continue to resist the increasing market pressure to hike interest rates. In these countries the FX reserves position is much larger than in Argentina, but spending billions of US dollars on a weekly basis to defend the currency is not sustainable in this environment.
The markets are clearly testing the three most vulnerable countries. These are crucial times for these three, but it is also a warning sign to other emerging markets that are not doing their homework enough, such as the Philippines and Colombia, and eventually also Brazil and South Africa if they keep on postponing the required reforms. In this context we need to flag that the most important event in the emerging world in 2018 is probably the October Brazilian elections.
