Rate calls take edge off emerging markets
Appetite for riskier returns may be dulled by planned US hikes
● While global banks and major funds still see opportunity in emerging markets, some investors are starting to tread cautiously.
The expectation of higher US interest rates and the yield on the 10-year US treasury note holding above 3% have strengthened the dollar and eroded some demand for riskier assets, resulting in emerging market currencies taking a knock.
Most emerging market currencies have slid over the past month, according to Bloomberg data.
A financial crisis in Argentina has seen the country raise interest rates to 40% to stabilise the Argentine peso, which has plummeted by more than 18% this month and sent the country to the IMF for help.
Over the same period, the Turkish lira has fallen by 10% as a result of President Recep Tayyip Erdogan’s pledge to tighten control on the economy after snap elections in June. The Mexican peso and Brazilian real are down 9.2% and 9.8%, respectively.
The rand has performed better than other emerging-market currencies, losing just 6.3% of its value in the past month.
Nazmeera Moola, co-head of fixed income at Investec Asset Management, said the rand’s relative performance was a reflection of a narrower current account deficit as well as increased optimism around structural changes to South Africa’s economy under Cyril Ramaphosa’s presidency. But how long the effect will last will depend on whether the market sees further tangible developments.
Global factors that have weighed on other emerging-market currencies have weighed on the rand.
The looming threat of a trade war between the US and China does not bode well for emerging markets. This week Japan said is it was considering imposing tariffs on US imports worth $409-million (about R5-billion) in response to the steel and aluminium levies introduced by the US.
Mike Keenan, a currency and fixed-income strategist at Absa Capital, said the decline in emerging market currencies had more to do with position clearing and profit taking as the dollar strengthened than a structural change in the “emerging market story”.
He said he expected many emerging market currencies to recover as yields are pushed higher and investors chase that profit. He and his team expect the rand to strengthen to around 11.75 to the dollar. But the rand was unlikely to breach the 11.50 barrier without a sustained surge in commodity prices, particularly gold, he said.
“We think that the emerging market story is still fundamentally a good one,” he said.
The World Bank expects emerging markets to drive global growth in 2018, with a growth forecast of 4.5% compared to 2.2% for advanced economies.
Despite this, Keenan said he expected more frequent periods of volatility for emerging market currencies than experienced in the past few years as favourable monetary policies in advanced economies come to an end.
The US Federal Reserve has signalled that it intends to hike interest rates four times this year. The Bank of England is also expected to increase interest rates, despite a slowing economy, while the European Central Bank also expected to start tightening its monetary policy, possibly next year.
“It’s going to be a bit more challenging for emerging markets than maybe it was in previous quarters when we really were in a Goldilocks kind of environment . . . but I think emerging markets still look pretty good,” said Keenan.
A “Goldilocks” environment — a term coined by David Shulman, a former Salomon Brothers investment banker, in 1992 — refers to conditions that are not too hot (causing inflation to rise too rapidly) and not too cold (slowing growth).
Even without the “Goldilocks” environment, emerging markets are still benefiting from better yield differentials on bonds compared to advanced economies.
Keenan said that on average emerging markets had a 3.5% higher yield differential over the US, compensating investors for the risk. In a case like South Africa, the risk premium was as high as 5%.
Keenan said emerging market currencies would have to weaken in a sustained way over a number of quarters to “eat away” at that premium.
But not everyone is so bullish about emerging markets.
Harvard professor Carmen Reinhart told Bloomberg this week that emerging markets are worse off now than in the 2008 global financial crisis and 2013 taper tantrum. Reinhart pointed to mounting debt, weakening terms of trade, rising global interest rates and stalling growth as major cracks in emerging market economies.
Capital Economics this week noted that emerging market export growth has started to soften.
But in another note, published last week, the research firm said that while capital flows to emerging markets had slowed there had not been a broad-based sell-off.
The emerging market story is still fundamentally a good one
Mike Keenan Strategist at Absa Capital