Emerging markets will present fewer snakes and more ladders in the future
EMERGING markets are having a year to forget. Even for foreign exchange and bond markets that are accustomed to the perpetual boom-bust cycle that has dogged the asset class since its inception in the 1980s, the past couple of months have been testing.
Historically, traders in emerging markets (EM) needed to navigate through complex issues such as greater corruption, political meddling and fewer legal protections. In short, they faced bigger risks, but with these greater risks also come greater rewards.
However, so far this year, the risks have overshadowed the rewards as market flare-ups in Turkey and Argentina have left traders reeling. There are, however, several reasons to believe that this time emerging markets are not headed for another annus horribilis and the previous pattern of crisis to default to recession will not be repeated.
The seed of this latest crisis was sown in 2017, which was a bumper year for emerging markets traders, as synchronised global growth created an improving backdrop. When traders returned to work following their Christmas holidays, the optimism was palpable as funds flowed into the asset class to the tune of $11.8bn (€10bn), dwarfing the $4.9bn (€4.2bn) of inflows witnessed in January of the previous year.
This money was betting that, with resurgent growth of over 4pc, EM would be the driving force for the global economy in 2018, taking over from the US and China. What markets weren’t ready for was a US dollar rally that inflicted heavy losses, gaining momentum over the past two weeks, and forcing a serious investor rethink.
A strong dollar is a hammer blow for EM investors for two reasons. First, a large proportion of the extra risk premium on offer comes from taking on currency risks. So the abrupt gains for the dollar, an increase of 4.5pc since April 17, cascaded into large foreign exchange losses for investors.
Secondly, a stronger dollar also makes any dollar debt that a country has more onerous to pay back. Turkey and Argentina have been two of the heaviest borrowers of USD debt over the past decade. Understandably, as the dollar has rallied, traders have grown concerned that these nations may now struggle to repay the billions borrowed, resulting in overweight investors dumping assets linked to these countries. Compounding this, bond yields in the US have been on the rise, with the closely watched 10-year Treasury bond breaching 3.1pc this week, with the knock on effect of pushing interest rates higher globally.
Turkey, in particular, finds itself in the eye of this storm — with the lira down more than 15pc versus the dollar since the start of the year, despite the best efforts of the Turkish central bank to stem losses.
Current expectation is that an emergency interest rate increase of more than 200bps may be required, although even this may not be enough.
As recently as last week, the Central Bank of Argentina raised rates three separate times, with two of those hikes coming within 24 hours. The benchmark interest rate in Buenos Aires now stands at 40pc and even this has not yet been enough to fully stabilise the peso, which has lost 22pc of its value this year.
A quirk of trading in EM is that, despite the vast differences in the economic position of a very diverse set of countries, when things turn bad, investors act like a fin has been spotted in the surf, fleeing en masse and reducing exposure indiscriminately across all emerging markets alike.
This can often present opportunities to investors willing to take a longer-term view.
Since the end of February the Brazilian real, previously viewed as a darling of EM, has quickly lost over 11pc of its value versus the dollar. Meanwhile the great hope for this year, the South African rand, is also under pressure — down close to 6pc — despite renewed optimism in the new direction of the country under the leadership of newly-elected president Cyril Ramaphosa.
Looking past the short-term market unrest, there are reasons for optimism for an asset class which has learnt many harsh lessons in the past and is now more resilient. Firstly, EM’s economic fundamentals remain sound, growth remains robust and is projected to strengthen further, again outperforming developed markets.
More importantly, EM is now running an overall current account surplus, a situation than in the past has led to stable markets. Countries such as Brazil, South Africa and others are no longer running the large trade deficits that put them at risk when the last crisis struck in 2013.
A further safeguard has been the gradual accumulation of FX reserves by developing nations. These reserves, combined with now freely-floating currencies, allows EM central banks room to relieve pressure on their economies in times of market stress.
The golden rule is that EM nations should maintain 10pc of GDP as FX reserves for a rainy day, which the majority now do.
Another pressure point for EM in the past was the over reliance on borrowing foreign currency debt, which often led to default concerns in times of crisis. While the total amount of EM-related dollar debt remains relatively high, most nations now rely primarily on debt issuance in their local currencies, which they can freely print as a last resort.
Finally, and possibly more crucially, the past 10 years has seen the growth of indigenous pools of EM money. Increasingly a large number of pension funds, investment managers and local banks, created to service a growing middle class in these countries, are now available and willing to be the buyer of last resort if required when opportunistic international money is withdrawn.
So while the short-term pain emerging markets are currently experiencing may not be over just yet, the final toll for markets is unlikely to be anywhere near the magnitude witnessed in previous episodes.
Emerging markets are much better positioned to withstand market shocks. Going forward, as they try to close the gap on established nations, there will be fewer snakes and more ladders along the way.