Traders work at the Buenos Aires Stock Exchange in Buenos Aires, Argentina. (Photographer: Diego Giudice/Bloomberg)

Argentina Sell-Off Risks Dragging Down Emerging Markets

(Bloomberg Opinion) -- This month’s sell-off of Argentine and Turkish financial assets, two emerging-market benchmarks, is less surprising than the minimal impact it’s had on other emerging-market securities. But before celebrating the resilience of that asset class, investors should take a cautionary look at the reasons for the limited contagion so far.

Easy credit and assurances of low interest rates by systemically important central banks such as the U.S. Federal Reserve and the European Central Bank have more to do with the short-term stability of emerging-market stocks and bonds than the overall structural strength of the asset class or favorable country fundamentals. That means that continued weakness of Turkish and Argentine assets could drag down the rest of the emerging markets all too soon, possibly even enough to make a contrarian investment attractive.

Whether you look at foreign exchange markets or default risk indicators, it’s been a particularly rough week for Argentina and Turkey. Both nations’ currency and credit default swaps are trading at their worst levels for the year. The situation is particularly alarming for Argentina, where the investor-perceived probability of default has shot up to over 60 percent (consistent with a 5-year CDS at 1,300 basis points). The country’s April 2021 bonds are yielding an eye-popping 20 percent.

All this is taking place in the context of a government elected on a platform of economic and financial reform, benefiting from exceptional financial support from the International Monetary Fund, and having recently successfully completed a mid-course IMF program review. Yet none of this is enthusing domestic and foreign investors.

Argentina is increasingly suffering through a cycle of financial disruptions, economic contraction, debilitating inflation and weakening creditworthiness ahead of October elections that are shaping up as a referendum on President Mauricio Macri and his reform program.

Yet looking at stocks along with debt, the emerging-market asset class has held on well this year. The spread on external debt is trading at around 370 basis points, according to the JP Morgan EMBI Global Spread Index, still notably better than the 440 basis points at the start of the year. Moreover, debt denominated in local currencies has been relatively well-behaved. And in the riskiest general segment of emerging-market securities, captured by the iShares MSCI Emerging Market exchange-traded stock fund, the index is up over 10 percent this year.

The jury is out on why the sector is holding up and whether it can continue to do so. National economic reform programs are losing momentum, and it’s hard to tell whether these, as opposed to the general liquidity conditions that have favored so many asset classes, are sustaining investor confidence.

At this stage, the most compelling argument for the strength of markets in the face of widespread economic struggles is related to the policy U-turn executed by the Fed last quarter when it scaled back projected interest-rate hikes for the year and announced a September end to its balance-sheet reduction program. The same factor is feeding talk of a long-term bull market dubbed — pick your favorite term — a general melt-up, FOMO (fear of missing out), riding the wave, or dancing because the music is still playing. And, as I wrote on Monday, such market exuberance is likely to fade in the next few months unless economic conditions improve, especially in Europe and China, and the Fed figures out how to pivot on interest-rate policy guidance again without spooking investors.

Even optimistic emerging-market investors should now plan for some contamination of the asset class from Argentine turmoil. Indeed, the case is building for a contrarian trade that involves increasing risk to Argentina and offsetting that by reduced risk exposure to emerging markets as a whole.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Mohamed A. El-Erian is a Bloomberg Opinion columnist. He is the chief economic adviser at Allianz SE, the parent company of Pimco, where he served as CEO and co-CIO. His books include “The Only Game in Town” and “When Markets Collide.”

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