Turkey’s debt downgraded to junk; crunch talks about the price of oil, Mexico braced for Trump-induced trade pressures, Russia called out for war crimes and Venezuela on the brink of default: so what’s new in emerging markets?
Investors have long possessed the capacity to rush headlong from one EM trade to another with indiscriminate haste. They flooded into EM at the start of this century, drawn by the great China commodity supercycle. In 2015, they ran for the exit amid fears of a slowdown in China and a crashing oil price; Now, once again, they are in a hurry to hoover up any EM asset going.
Despite a regular diet of problems befalling the EM universe — nearly all related to political risk — the mood among investors remains upbeat. Analysts have spent much of the year forecasting the demise of the EM rally, particularly in the foreign exchange market, but have been confounded.
Puzzlement remains. Why, asks Nomura FX strategist Bilal Hafeez, has the Mexican peso felt the backlash of investors gripped by Donald Trump’s protectionism polemics when Asian currencies like the Korean won and the Indonesian rupiah have not?
“One of these markets is wrong,” says Mr Hafeez.
Why, wonders Luis Costa of Citigroup’s FX strategy team, are Turkish bonds now trading at levels seen before the country’s downgrade by rating agency Moody’s? “When we saw the downgrade, we were talking about forced selling,” he says.
Idiosyncrasies aside, the EM rally is proving resilient. Three reasons help explain why. First, worries about China have eased. The People’s Bank of China has communicated policy more effectively and the economic data — putting aside whether investors truly believe them — give no cause for alarm. The renminbi has been allowed to depreciate with barely a squeak from the market.
Secondly, terms of trade across EM have improved. With the exception of China and Saudi Arabia, EM current account balances are back in the black. The deficits in the current accounts of Brazil, South Africa and Russia — whose currencies make up three of this year’s top four spots in the foreign exchange performance rankings — have all been narrowing. So has Turkey’s.
Thirdly, the low rate backdrop of developed markets makes the EM yield story attractive. Peter Kinsella, EM strategist at Commerzbank, says that while sentiment for EM will wane periodically, there is good reason to expect it to be running in its favour for the time being.
How long can the emerging market bond rally run?
Moment when tailwinds turn will be hard to predict
“The debate in G3 [US, Japan, Europe] has gone from ‘low for longer’ to ‘lower forever’, so you are likely to see investment going towards EM for quite some time yet,” he says.
Since the height of those worries about China in January, JPMorgan’s EM FX index has risen 8.9 per cent.
Risk appetite may not quite be insatiable, but it is strong enough to override concerns such as the state of the European banking system. Despite the woes of Deutsche Bank, “you haven’t really seen much contagion to broader markets”, says Mr Hafeez.
That is not to say all EM investment is indiscriminate, or that investors are shirking their homework. India’s rupee has quietly been climbing, supported by what Mr Hafeez calls “a good underlying fundamental story” that insulates it from the ripple effects of China’s slowdown, a reformist administration and high interest rates.
Yet a well liked currency such as the rupee is still at the mercy of events. Surgical strikes on Pakistani militants on Thursday sent the currency sharply lower.
Political risk is never far from the deliberations of the EM investor. Pockets of concern can be found on a daily basis. Nothing, however, gets the EM investor base more exercised than the health of the US economy and the direction of interest rates.
“The biggest risk to EM is further deterioration in US data,” says Mr Costa. “That can be a kick in the head for global growth risk.”
Perversely, EM currencies could also weaken if the US economy strengthens. Barclays expects the dollar to rise around 5 per cent over the next 12 months because of monetary policy normalisation.
It is reserving judgment until the outcome of the US elections — a reminder that political risk is by no means confined to emerging markets.