Emerging-Market Laggards Get Reality Check as Fed Veil Lifts
(Bloomberg) -- The term “emerging markets” can conjure up the image of a homogeneous asset class that sits nicely on one rung of the risk ladder. Nothing could be further from the truth.
As the tide of U.S. monetary stimulus recedes, it’s becoming clearer who’s swimming naked. On the one end are nations with the promise of rapid growth and increasingly open economies. On the other are political tinderboxes that hold investors hostage to their power-grab dramas.
In between are the also-rans, with spiraling debt burdens, volatile inflation and crummy trade accounts to boot. These three categories have been treated as one investable pool in the era of Federal Reserve support, but as capital becomes scarcer, it may no longer be wise to gloss over the discrepancies between them.
The graphic below uses forecasts and economic data compiled by Bloomberg to sketch the diverse market landscape for developing nations next year:
“There has not been much differentiation in recent years,” says Kenny Tjan, who helps oversee $17 billion as investment director at Value Partners Asset Management Singapore. “Investors just looked for exposure to emerging markets so that they don’t miss out on the rally. Next year, the overall performance may not be as good. The catalyst would have to come from looking for differentiation.”
The axe of tighter monetary policy will fall on all emerging-market currencies, but the deepest cuts may be suffered by those that nurse wounds of their own making. Money managers call these idiosyncratic risks -- the key to asset allocation when markets aren’t swayed by global macro forces.
Here’s a run-down of the key differentiators:
The risk that domestic and international rows can derail investor gains has worsened in 12 of the top 20 emerging markets this year, according to Bloomberg political-score indexes. Money managers don’t sell every time there’s an election, leadership scandal or street protest. They press the panic button only when the noise affects policy making, threatens private property or undermines central-bank independence.
Turkish President Recep Tayyip Erdogan’s renewed outbursts against higher interest rates and the power struggle in South Africa’s ruling party are cases in point. Other risks:
- Populist leaders are gaining in polls in Brazil and Mexico. In Colombia, former guerrilla Gustavo Petro has support for raising taxes on stock investors and wealthy landowners. Chilean left wingers are also resurgent
- South Korea is on edge because of its northern neighbor’s nuclear-weapons program
- Thailand says it will end military rule next year, but analysts suggest the army may continue to exert control
- Pakistan, which won emerging-market status from MSCI Inc. in June, is under siege from religious fundamentalists that allegedly have military backing
Real yields for investors are set to rise in many emerging markets. Bloomberg forecasts for inflation this year and the next suggest India, Indonesia, Malaysia and Latin America may witness a widening gap between nominal rates and price growth.
However, prices may rise faster in China, Russia and Brazil, shrinking real yields. Returns may even turn negative in Chile, like they already have in Turkey.
Eight of the 20 economies may see inflation accelerating next year, according to Bloomberg forecasts. The ability of central banks to increase interest rates could determine money managers’ interest in them.
Russia comes out the worst by this parameter, because economists expect a rebound in inflation, but the central bank may continue its dovish stance because of the stalled economic recovery. The ruble was briefly the worst performer in emerging markets on Friday after policy makers surprised with a deeper-than-expected rate cut.
Societe Generale SA says the bulk of currency returns in 2018 will have to come from carry trades, which meaning policy makers will have to bear in mind higher U.S. yields when adjusting their own borrowing costs.
- BlackRock Inc. sees room for monetary easing in Indonesia, but the central bank says rates are low enough
- Brazil may not raise rates though some inflationary pressure is expected next year because of a negative output gap
- Colombia’s expansionary policy is set to continue even after 300 basis points of rate cuts as the economy grows slower than expected
Improving external balances have largely been an Asian story. While the continent leverages its status as the world’s manufacturing hub, some other emerging markets aren’t that strong.
Across Latin America, current-account deficits may widen over the next three years, according to economists’ forecasts. Turkey has the biggest shortfall in the developing world. South Africa’s deficit is stabilizing but is still above 3 percent of its gross domestic product.
The health of external balances may receive greater attention next year as higher U.S. interest rates make it harder for governments to raise cheaper funds or refinance their debt.
A stronger dollar means some emerging-market central banks may have to dip into their foreign-exchange reserves to curb currency volatility.
- Turkey and South Africa have enough cash in reserve to cover half a year of imports. Compare that with China, which has $2 in store for every dollar it spends on imports
- Pakistan can cover only four months of its imports, but the $2.5 billion it raised in a November bond sale may ease the burden
A surge in borrowing has exposed China to the threat of a financial crisis, where the country has about $3 of debt for every dollar it produces. The debt-to-GDP ratio is projected to soar to 327 percent in 2022 from 259 percent in 2016.
Fiscal balances in emerging markets have deteriorated on average since 2013 and may prove to be a source of vulnerability in select markets, according to JPMorgan Chase & Co.
As for external borrowing, debt-to-equity ratios are rising in most of Latin America, emerging Europe and Africa.
©2017 Bloomberg L.P.