Interpreting emerging market squalls

Developing economy policy-makers contend with heightened risk

The optimism of early 2018 that the previous year’s double-digit emerging market stock, bond and currency upswings would persist was overtaken by the end of the second quarter. All asset classes are in decline amid fears of a liquidity and economic squeeze reprising the 2013 Federal Reserve-induced taper tantrum.

Advanced economy central banks are winding up their quantitative easing programmes that had been thought to have contributed to portfolio flows towards the developing world. However, over a decade the correlation could not be proved, and major emerging markets often employed loose monetary policies as well. Average annual GDP growth and inflation forecasts in the 4%-5% range have been relatively consistent over the past six months, while trade and geopolitical risks have been heightened since the onset of Donald Trump’s presidency. Policy-makers should not revert to five-year old explanations for renewed emerging market squalls that rely on external forces, such as the stronger dollar.

According to fund trackers, foreign investor inflows turned to outflows in May, but net allocation was $20bn for local and hard currency bonds, and $35bn for core and frontier equities at the end of June. Stock market earnings and valuations were steady, with the latter still at a sizeable discount against advanced economy counterparts. International sovereign and corporate issuance was on target with gross totals of $100bn and more than $200bn respectively, and rollovers were managed with recycled cash flows. Almost all currencies were down against the dollar, although this trend retraced previous appreciation (with the exception of countries like Argentina and Turkey with large payment imbalances). Central banks and securities regulators did not panic as they prepared policy and rate defences. Argentina bolstered its backstop by turning to the International Monetary Fund for a standby programmes, with $15bn immediately released from a $50bn line to cover external financing needs into next year. Outright crisis was further contained in the light of index provider MSCI’s decision to reinstate core index status, reflecting capital market modernisation under President Mauricio Macri.

China, as the country with the largest MSCI weighting, received only a short-term bump from ‘A’ share inclusion. Investors bridled at poor governance practices in both state and private company listings amid festering trade and debt concerns that are widespread in Asia and other regions. Struggles with global trade deals such as the Trans-Pacific Partnership and North American Free Trade Agreement have been countered with the formation of smaller deals between emerging economy blocs, but progress here has been slow. The TPP is yet to be resurrected as a biregional Asian-Latin American arrangement; the European single market is under pressure from Britain’s exit and the cutting of ‘cohesion spending’ for eastern European countries; and even with breakthroughs for Africa’s the details are murky and subject to long phase-in periods. New agreements such as this are made more urgent by the fact that foreign direct investment in developing economies – historically a multiple and driver of the portfolio number – was flat at $700bn in 2017, according to United Nations records.

Emerging market foreign reserves have rebounded from a year and a half of depletion, especially in Asia and the Middle East. External corporate debt, on the other hand, faces a heavy repayment schedule through 2019, and private borrowing remains a vulnerability despite official deleveraging campaigns. Credit has continued to outpace GDP growth over the past decade, and banks have not reckoned with bad loans under an extended favourable business cycle that may now be turning, especially without underlying productivity gains that should also be a priority for policy-makers.  As the asset class tackles these issues on its own terms, second half results are poised to selectively improve in line with country commitments, and a second post-taper tantrum wind can banish the concept as a different future rationale dominates.

Gary Kleiman is Co-Founder and Senior Partner at Kleiman International.

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