Emerging market trials persist

2018 decline across investment classes prompts allocation reconsideration

Last year’s thrashing in all emerging market investment classes, with debt, equity and currencies in simultaneous decline for the first time in a decade, cast equal blame on internal and external forces and prompted reconsideration of allocation rationale into the next decade.

Crises in Argentina and Turkey in 2018 were in part a replay of 2013’s Federal Reserve-induced ‘taper tantrum’, as retail foreign investors sold indiscriminately without detailed knowledge of economic, financial system and technical underpinnings. Contagion may yet spread, but for now index performance will continue to be subdued without the spectre of uncontrolled crashes. A worst-case scenario involving a meltdown in the Chinese economy would damage world markets, unlike the version a decade ago when the rest of Asia and commodity exporters suffered most of the consequences.

The dollar’s strength against all emerging market currencies was a drag, but may again fade as developing economy central banks raise benchmark rates, contributing to slower growth. Government borrowing for possible fiscal stimulus will reinforce tightening pressure, against the backdrop of mixed commodity prices and credit ratings trends. Lower hydrocarbon values, with oil falling to $50 per barrel, prompted sovereign and corporate downgrades.

Populism is on the rise, especially in Central Europe and Latin America. Geopolitics, in turn, increasingly focuses on trade and aid conflict between Washington and Beijing and their respective allies. Tariff retaliation and pact renegotiation will become standard tools. Spikes in financial market volatility from computer-driven trading and debt-equity rotation add to the cross-currents affecting asset choices.

The International Monetary Fund downgraded its average growth forecast to 4.5% this year on inflation slightly below that level. Foreign trade and investment will slacken and stay in the $1tn range to major emerging markets, according to the Institute for International Finance. Short-term reserve coverage as a portion of external debt is thin beyond Argentina and Turkey, in places including Chile, South Africa and Pakistan.

Structural reform momentum stalled during the easy money era. India held up as a rare bold example, but its reputation was dented by the resignation of Urjit Patel as governor of the Reserve Bank of India over government interference, though he cited personal reasons. Monetary policy independence may now be at risk as authorities also grapple with the fallout of large corporate and household debt loads on bank health. Across the world and particularly in China, shadow banks and financial technology providers are new intermediaries in the system that often escape regulation and have not experienced distress.

Fund trackers put stock and bond inflows at less than $20bn each in 2018, with a meagre increase predicted this year. For the former, China and South Korea were favoured destinations because of their large weight in the MSCI index, and technology companies are also a large component as the global industry cycle sputters. Valuations are widely discounted to developed markets, but earnings growth is lacklustre and fast-moving exchange traded funds account for one-quarter of participation. In bonds, sovereign and corporate issuance droughts lasted for months in 2018, and this year’s totals are projected to fall further to limit refinancing; $2tn in combined local and foreign currency maturities will come due in 2019. Official defaults would already be widespread in Africa without IMF programme rescues, and recent Middle East entrants look to JPMorgan index inclusion as the remaining catalyst with reduced placement. While conditions remain sobering, markets and classes will turn selectively positive, as complex layer appreciation returns to replace knee-jerk reactions in determining direction.

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

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