Comment: Turkey highlights divergence in emerging markets
As the Turkish lira continues to weaken, Stéphane Monier looks at the impact across emerging markets generally, and assesses what investors should be alert to in individual countries, sectors and companies.
Five years ago, emerging markets set off on a rocky road as the so-called ‘taper tantrum’ rattled investors. The US Federal Reserve’s (Fed) slow roll back of quantitative easing and the eventual resumption of rate hikes led to weakness across asset classes in developing nations. From January 2013 to the end of 2015, when the Fed did indeed make its first post-financial crisis hike, the MSCI Emerging Markets equity index fell by close to a third. Fast forward to 2018, and the US is firmly in tightening mode, the dollar is strong, US rates are on the up, and emerging markets are feeling the pinch once again.
Coupled with sustained global trade tensions, this environment magnifies shocks and highlights the importance of a selective approach to the asset class. Emerging markets are indeed vulnerable with the US in a tightening phase, but investors are now more willing to reward the strongest and punish the fragile. This summer’s crisis in Turkey has made that amply clear.
We have been warning of difficult conditions in Turkey for some time. The latest trigger for losses on Turkish assets has been a diplomatic spat with the US. However, the root cause lies in deep macroeconomic imbalances that we have highlighted since the fall of 2017: a weak external position and the central bank’s unorthodox reaction to rising inflation. The latter has been influenced by political overreach from President Recep Tayyip Erdogan who has openly sought to dissuade the central bank from delivering interest rate rises.
The impact has been dramatic. The lira (TRY) lost more than 40% against the dollar before recovering, while credit default swap (CDS) spreads – which act as a measure of investor confidence that a country will repay its debt – rose to their highest level since November 2008. Investors are rightly concerned about the risk of contagion into other emerging markets as US tightening acts as a form of stress test for imbalances in these growing economies. We expect the Fed to raise rates twice more this year and at least three times in 2019, and so the stress will be increasing for a while.
One thing to bear in mind is that certain key emerging markets enjoy better fundamentals than recent stock market developments might suggest, or than investors might feel. In fact, if the heat is taken out of trade tensions and if the dollar stabilises or even decreases slightly, then we would expect a solid rebound in the healthiest countries. In the meantime, however, the markets are under pressure. Over the year to date, the MSCI EM equity index has fallen by about 10% while the MSCI World index of developed markets has nudged up a little more than 1.5%. The MSCI EM currencies index, meanwhile, is off about 5% since 1 January. In debt, the JPM Emerging Markets Bond Index (EMBI) Global is down by 3.28% year to date.
Our detailed analysis signals Russia, China, Thailand, India, Malaysia and Korea as the top picks in the emerging market space, based on an assessment of macro fundamentals such as inflation, external debt and industrial production. We also factor in our more qualitative view on elements such as resource independence, demographics and political stability.
So which countries lie at the bottom of our list? It will be no surprise that Venezuela is the least attractive, while Turkey was already in the danger zone. Our assessment is that Argentina and South Africa look vulnerable based on fundamentals, and are therefore prone to attract the negative attention of those spooked by events in Istanbul. The Argentinian peso (ARS) and the South African rand (ZAR) are down against the USD over the year to date, by close to 40% and about 16%, respectively.
In Latin America, Colombia should be closely monitored, especially with the flow of Venezuelan refugees potentially straining social services. Mexico boasts relatively solid fundamentals but uncertainties linked to NAFTA could trigger further volatility. Brazil will remain under the spotlight in the context of the upcoming presidential elections in October and its implications for the country’s fiscal outlook.
In Asia, while most of the countries on our radar display strong fundamentals, we should not be complacent about the indirect impact of a potential trade war between China and the US. In this context, if renminbi (RMB) weakness were to become too significant, some of China’s neighbors might be challenged. At this point, we note some signs of overheating are emerging in the Philippines, while Indonesia’s reliance on foreign investors to buy its sovereign bonds means that the central bank could tighten its policy further, in order to support its currency.
Selectivity is key
Despite volatility, pressure from a stronger dollar and rising interest rates, emerging markets can offer opportunities for investors who can focus on fundamentals and tolerate swings in market sentiment. In fact, the arrival of selling pressure on all emerging markets is precisely what creates opportunities for those who make time and effort to understand the fundamentals of individual countries, sectors and companies, and who are willing to look past short-term volatility.
Emerging markets countries for the most part have learned the lessons from previous crises and their dependence on foreign portfolio inflows is materially less than in the past – Turkey, South Africa, and Argentina notwithstanding. Emerging markets corporate borrowers have been focusing on deleveraging for several years, in contrast to companies from mature markets, which are on the opposite trajectory. As a result, balance sheets are relatively strong and companies are in a good shape to deal with end-of-cycle challenges. Capital markets will remain open for financially sound companies and countries. Equity prices, meanwhile, are driven by profitability and growth. Investors should therefore carefully evaluate the balance of risk and reward for each country and each asset class. Our analysis, illustrated in the appendix, demonstrates that at this point in the market cycle, equities continue to stand out as the most interesting emerging asset class, followed by emerging market fixed income in local currency, and emerging market fixed income in hard currency.
Emerging markets can deliver profitability and growth that is structurally higher than the rest of the world over the long term, but they will remain vulnerable to short-term sentiment, geopolitical events (trade tensions) and the rising cost of capital, which is why selectivity is crucial at the country and asset class level. Turkey’s rough few months are a useful reminder that idiosyncratic risks persist. In the context of rising real rates in the US, the weakest links will undoubtedly be challenged in the coming weeks and months, and consequently, we might make additional, selective cuts to our emerging assets exposure as part of overall portfolio risk reduction.
Stéphane Monier is chief investment officer at Lombard Odier