Many emerging equity markets are now in bear market territory, having tumbled by 20% this year. A number of currencies reached historic lows, while external bond spreads widened. Such sell-offs often offer opportunities to investors. But to understand whether the current sell-off represents such an opportunity, it is important to understand the causes behind it.
A less hospitable external environment
Since the beginning of the year, we have argued that the global economy is entering a phase that is less hospitable to many emerging markets. Rising US interest rates increase the cost of financing for economies that are dependent on external borrowing. Increasing protectionism increases uncertainties in trade-dependent economies.
These pressures are happening at a time when emerging markets, as a whole, are no longer enjoying current account surpluses. China’s surplus diminished as domestic consumption increased. Most commodity prices have stabilised at levels below the peaks seen 10 years ago. Taken as a whole, emerging markets are now running a current account deficit.
While these pressures were well understood, the tipping point did not come about in full force until May 2018, when the dollar exchange rate soared. A stronger dollar increases the debt service of countries with foreign financing.
The combination of the common external pressures, however, are not sufficient to explain the sharp adjustment of emerging market asset prices. Funding costs are increasing but monetary conditions remain far from tight in all large economies. Trade disputes with the US have erupted but remain bilateral.
A coincidence of country-specific factors
The scale of the sell-off in equities and currencies can only be explained by a combination of country specific weaknesses. Brazil’s elections loom large, with little visibility of whether the results can produce a government that is able to tackle the country’s most pressing issue: pension reform. Argentina’s slow pace of reform has left the country vulnerable to the vicissitudes of capital flows. Turkey’s President has been consolidating control while exhorting an unsustainable policy mix of low interest rates and public spending. Mexico is in the midst of finalising a new NAFTA agreement, while undergoing an important political transition. In India, the fiscal deficit widened while new policy initiatives ground to a halt ahead of the general elections due in April 2019.
While these examples highlight the sensitivity of some markets, it is important to recall that the balance of payments positions of most countries are very manageable. With the notable exceptions of Turkey and Argentina, current account deficits are at or below 3%, while some countries are still running surpluses. These are levels that can be sustainable, even at higher interest rates, assuming the global economic growth backdrop remains favourable and policies are adjusted.
Risks to growth calls for being selective
If pressures are indeed manageable, and uncertainties are likely to dissipate in the months ahead, then does the recent sell-off in emerging markets provide a good opportunity for investors? The answer is yes, but only for some.
An often underappreciated risk to emerging markets lies not in the Trump administration’s trade disputes, or rising interest rates, but rather in China. China is the largest contributor to global growth, and consequently a larger source of export growth than the US.
The real risk is China. Indeed, even in economies as disparate as Russia, Mexico, and Brazil the correlation between export growth and Chinese imports is over 0.8.
The challenges to China’s economic model are escalating. As we have argued in our last note, credit growth continues at a high pace, raising the overall level above 300% of GDP. Measures to reduce overcapacities in some sectors are designed to increase the profitability of state-owned enterprises, rather than improve overall economic efficiency by reducing the size of government. Over the past year, productivity growth turned negative. The trade war with the US risks escalating into increased red tape for foreign investment. It is no surprise that investment growth has already decelerated sharply this year.
Against this background, while we see considerable opportunities in emerging markets, we are also cognizant that economies that are highly leveraged to China’s growth are likely to continue to see significant volatility. This implies that in the equities space, we continue to see more favourable opportunities in economies that are mostly closed. We continue to have a favourable long-term view on Indian equities, despite recent policy slippages and setbacks. Brazil is also attractive at current exchange rate levels. An allocation to global emerging markets equities funds or ETF, however, is less compelling given the sheer size of China and closely-linked Asian markets in the index. In the fixed income space, we see that spreads on dollar-denominated bonds have widened to levels that are attractive relative to comparably rated corporate bonds. We therefore increase our allocations to emerging market bonds, while maintaining preference for shorter durations.