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Emerging market gains set

by Gary Kleiman


In 2017, the performance of emerging market bonds and stocks exceeded the most optimistic early-year expectations. Fears of global monetary and trade squeezes proved overdone, paving the way for rallies across the asset class. The 35% rise in the MSCI index led double-digit benchmark increases across the asset class. Almost all countries were part of this trend in a pattern last seen a decade ago before the financial crisis.

Last year’s combined investment fund flows of $200bn mirrored the previous peak. Exchange traded funds, which have since mushroomed, accounted for 10% and 25% of debt and equity allocations respectively. Better than expected corporate earnings and average 5% GDP growth approached the level of boom periods.

However, the rally did not distinguish between asset classes and leaders and laggards within them, and overlooked geopolitical and banking system problems. Financial stability may be a prominent theme after years of post-crisis relief. Private sector leverage is causing concern and the public sector has limited capacity to mount rescues, due to steeper fiscal deficits.

Asia outstripped Latin America and Europe. MSCI’s inclusion of Chinese A-shares and buoyant company profits drove the global tech cycle and neutralised concerns over stresses in China’s banking system, corporate debt overhang and capital outflows. Authorities have announced crackdowns on state-enterprise leverage, deposit withdrawals by bank card holders and entrusted loans, where an agent bank organises loans between borrowers and lenders, in the shadow banking system. They have signalled further action, as financial stability is a priority of the ruling Communist party.

Foreign exposure to bonds
In contrast with 2008, economic and credit spillovers from China’s potential crises would now hit emerging market bonds as well. Foreign investors’ corporate and sovereign exposure rank near the top globally in surveys by the Emerging Markets Traders Association. South Korea, Malaysia and Thailand are grappling with high household and business debt. South Korea’s central bank stood out last year by hiking interest rates and imposing credit card curbs to shrink the country’s personal leverage, which was 150% of GDP, the highest in the Organisation for Economic Co-operation and Development.

In Europe, Russia lagged behind with a barely positive MSCI result despite low valuations. It may face more western sanctions for election interference, as the US Treasury is considering a ban on buying government bonds. Turkey’s 35% rise was due to official loan stimulus overheating the economy after the 2016 attempted coup.

Foreign investors trimmed local bond positions in Hungary and Poland in reaction to populist administrations courting EU condemnation, and fears that domestic institutional investors lack back-up capacity after private pension fund shutdowns.

Latin America has a packed 2018 election calendar. In presidential contests in Brazil, Colombia and Mexico the main parties are offering scant commodity diversification and productivity-raising platforms amid scandals and criminal investigations. Brazilian banks continue to deal with large corporate borrower restructurings. Argentina’s economic policy turnaround and capital market re-entry under President Macri resulted in record borrowing and a near 75% MSCI frontier index bounce in 2017. This was offset by Venezuela’s implosion under a harsher socialist regime bringing hyperinflation, debt default and a humanitarian catastrophe.

Political jitters
Frontier market stumbles in the Middle East and Africa left the composite gauge 10% below MSCI’s main roster. The boycott of Qatar by its neighbours has hurt Gulf states. Political jitters in South Africa and Zimbabwe affected bank liquidity and profitability.

It should serve as a warning to the asset class that the Institute for International Finance’s lending conditions survey returned a neutral result. Stock returns will probably continue to catch up with bonds over the long term, but there will be wide variation depending on individual countries’ political and economic circumstances.

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