After the batterings dealt out to Argentina and Turkey by financial markets this week, investors are looking at whether other emerging market countries with fiscal and monetary imbalances also face a reckoning.
Both Argentina and Turkey suffer from deep fiscal and current account deficits and a reliance on foreign funding. Both have made policy mistakes that have shaken investors’ confidence, Turkey especially so.
A further rise in 10-year US Treasury yields and bursts of dollar strength loom large over EM. Yet applying the lessons learned from the past week is not straightforward, and may miss the point: while many EMs are vulnerable at the moment to shocks such as the one this week, in the long term, many analysts said that their solid growth potential will outweigh such short-term difficulties.
David Spegel of Fundamental Intelligence, Strategy & Analytics (Fisa), an investment consultancy, said that, in the long term, the growth potential of emerging economies will outweigh their imbalances when it comes to attracting investment.
The contribution to global economic growth of 81 developing countries in Fisa’s database, which fell from 2011 to 2015, a period of underperformance for EM equities, has risen since 2016, coinciding with the EM equity rally. Mr Spegel expects it to continue rising throughout his forecast period to 2025.
But short-term worries persist. While Argentina’s problems appear clear in hindsight, for Adam Slater of Oxford Economics the country does not even feature in his list of the four economies most exposed to the still-unfolding effects of much higher Treasury yields since last September. Those four are Turkey, Brazil, Chile and Malaysia, followed by a second group of Colombia, South Africa and Argentina.
Mr Slater warned that the large build-up in EM debt of the past decade means economies are especially exposed as financial conditions tighten. “The worst situation is to have a high debt service ratio [to GDP] and one that is vulnerable to rising US dollar rates,” he said.
Mr Spegel shares such concerns but his analysis is different. In a note to clients this week, he looked at the hard currency defences of EM — measured in foreign exchange reserves, net foreign direct investment and the current account balance — in relation to maturing long-term debt (he ignores short-term debt because it is often collateralised or a measure of trade finance).
By such measures, EMs as a whole are more exposed than ever. Since 2001, by Mr Spegel’s calculations, the stock of foreign investment in EM equities and local debt has risen from $1.2tn to $6.9tn, and is well above its level before the global financial crisis.
And EM defences are weaker. Excluding China (because its reserves are distortingly large in relation to foreign portfolio investment), since the second quarter of last year, for the first time since the eve of the crisis, the stock of foreign portfolio investment in EMs has exceeded those countries’ stock of foreign reserves.
“What matters is your stock of foreign assets relative to the potential for foreign outflows,” said Mr Spegel. “If that stock is insufficient to meet whatever the flight might be, no matter how great your economy is, your balance of payments will be at risk.”
EM’s soft underbelly is helping to fuel uncomfortable perceptions. Stephen Jen of London-based hedge fund Eurizon Capital said EM has a “Eurozone problem” because of the wide disparity in macro economies across component parts.
He added that just as eurozone investors focus on strong economies such as Germany, and on weaker links such as Italy or Greece when they are bearish, so EM investors are heavily influenced by the vulnerability of Argentina, Turkey and other countries even if in broad terms EM economic fundamentals have not deteriorated much.
“The fact that there is not a single focal point, as is the case in both the US and China, makes EM and the EMU susceptible to wide mood swings,” says Mr Jen.
Still, sentiment towards EM is far from one of panic selling. Volatility may be infiltrating EM, acknowledges Monica Defend of European asset manager Amundi, but that in itself doesn’t make EM unattractive.
A strong dollar, higher US interest rates and idiosyncratic issues make conditions tougher in EM, but “these adjustments are absorbed through higher spreads and weaker FX EM, so opportunities may open again”, said Ms Defend.
Investors know, however, that there are consequences for EM economies from this ongoing retreat. Indonesia’s central bank has increased interest rates for the first time in four years following a 5.5 per cent decline in the rupiah since the start of February, seeking to halt capital flight.
India has also seen a drift of capital after record inflows last year, while its economy is also affected by Brent crude rising to $80 a barrel because of its dependence on oil imports.
Oil’s rise is overshadowing how investors see EM. Xavier Hovasse, head of emerging equities at the European fund Carmignac, said EM should “still do well globally”, but the fund is starting to differentiate between oil importers and exporters. So Carmignac is cautious about importer Turkey and less worried about oil producer Russia.
Overall, EM “looks very different from six months ago”, Mr Hovasse added. “Some countries that looked extremely good are now in trouble.” But variable issues such as oil, current account balances and geopolitical factors show how complicated it can be to judge EM as a whole.
“There are winners and losers. People understand the concept of ‘emerging markets’ doesn’t make that much sense,” said Mr Hovasse. “Countries with huge external surpluses like Taiwan and Korea shouldn’t have anything to do with Brazil, South Africa and Turkey.”
Except that in a risk-off climate, there is a nagging temptation to exit EM assets wherever they are. The test for EM in the coming weeks is to see just how discerning the investor is prepared to be.
“The worry about contagion is that it just dominates everything,” said Larry Lau, fund manager of the Trium Diversified Macro Fund, a London-based alternative asset manager.
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