Are emerging markets still attractive for investors? Looking beyond Argentina, Turkey and the US dollar...
Emerging markets (EM) are once again dominating the financial headlines; and not in a good way. Both Argentina and Turkey are in the midst of a financial battering and while the problems within both economies appear to be very much of their own making, we need to ensure that these travails are not symptomatic of a wider malaise. If they are, we may be forced to reappraise our investment positioning towards emerging markets.
Argentina’s interest rate hits 40%
In Argentina’s case, the central bank has been forced to raise its key interest rate to 40% to try and control rampant inflation and defend the value of the peso. Consumer price inflation breached 25% during April, while the peso has slumped 34% against the US dollar since the start of the year. The country’s fiscal position is particularly worrying. Public sector deficits increased substantially in 2015 due to collapsing commodity prices and a rise in election spending and yet, despite the election pledge of President Macri to gradually improve this position, the deficit has only widened since.
Turkey’s lira free falls
So too, the Turkish lira has plunged to a new low versus the US dollar and 10-year government bond yields have surged to over 14% as President Erdo?an not only failed to offer comfort to financial markets, but seemingly went out of his way to antagonise the investment community. Rather than offer relief that the necessary economic decisions would be made, which would have necessitated a rise in interest rates to counter inflation of over 11%, he derided interest rates as the ‘mother of all evil’. He then insisted that rates must be cut and confirmed that he remains committed to adding additional fiscal stimulus ahead of June’s election. It’s fair to say that Turkey’s financial markets have not responded well.
Even excluding these idiosyncratic episodes, emerging market assets have not fared well so far in 2018, with a combination of US dollar strength, tightening US financial conditions and heightened political uncertainty all undermining confidence. Emerging market bonds, as measured by the JP Morgan EM Bond Index, have fallen by nearly 7% since the turn of the year. Currency markets have also come under pressure and while the MSCI’s EM Equity Index hasn’t fared that poorly in absolute terms, the underperformance relative to global equities has been disappointing for those who have chosen to overweight these developing regions.
As we assess the future prospects for EM, it appears that the performance of the US dollar is inextricably linked and is a key, if not the key consideration.
The impact of the US dollar on emerging markets
A strong US dollar has historically been a severe headwind for developing economies. The 6% appreciation in the broad, trade-weighted dollar since the end of January has unfortunately coincided with a period when certain country specific issues - such as those within Argentina and Turkey - have come to the fore. The potential of a trade war has also undoubtedly soured sentiment towards EM.
The long-standing correlation – US dollar strength and EM underperformance – is based on a number of variables, although there are three reasons most often cited:
- First, a rise in the dollar increases the cost for EM repaying US dollar denominated debt. While the scale of this borrowing has significantly reduced over the past few years, it continues to exert an influence.
- Second, there is a long-standing inverse correlation between the US dollar and commodity prices. As the dollar gains, so commodity prices fall and vice versa. As a whole, and excluding economies such as China and India, EM are a net exporter of commodities. They therefore tend to suffer when commodity prices weaken and this is partly why Argentina’s fiscal position deteriorated so markedly in 2015.
- The third factor is that many EM central banks actively intervene in currency markets in an attempt to try and smooth exchange rate fluctuations. EM in aggregate hold about 40% of their external assets as reserves; reserves which are often depleted in an attempt to slow, or try to halt, currency depreciation. A period of dollar strength can both increase an EM’s liabilities (greater debt servicing costs), as well as reduce the value of its reserve assets (through currency intervention). This is therefore a double-whammy to an EM’s balance sheet.
We would not be surprised if the US dollar’s current strength were to prove transient. Despite rising interest rates, the US dollar often falters when growth in the rest of the world is converging with that of the US, which is arguably the case at present. We must also recognise that, from a technical perspective, the US dollar was previously very oversold; this has now largely been unwound and the dollar looks fully valued, particularly relative to the euro and yen.
Looking beyond Argentina and Turkey – the case for investing in emerging markets
Economic fundamentals across the EM universe have improved significantly in recent years. While countries such as Argentina and Turkey, with large deficits, high amounts of debt and significant inflation, are particularly vulnerable to the effects of US Federal Reserve tightening, they are not reflective of developing economies as a whole. There are many countries which run surpluses and even in countries where deficits continue to be run, they have often declined as a percentage of GDP.
Inflation at an aggregate EM level is also on a par with that of the US. With all of these issues in mind, we do not believe that now is the time to become overly pessimistic on the prospects for EM assets. Financial history is replete with broad EM crises – the 1982 Tequila Crisis and the 1997 Asian Crisis are amongst the best known. 2018 may bring with it a crisis in Argentina; arguably it is already in the middle of one such period. However, this is not likely to spark broader contagion and it is doubtful that, in years to come, we refer to 2018 as the year
of the Gaucho Crisis.
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IMPORTANT: Investment involves risk. The value of investments and the income from them can go down as well as up and you may not get back the amount originally invested. Past performance is not a reliable indicator of future performance.