One truism spanning the last three decades has been that emerging markets are a leveraged play on global growth – often outperforming when developed markets (DM) are growing but susceptible to sharp downturns when DM conditions are less favorable.
While this trend remains intact, understanding what has changed in the wake of developed market financial crises and the shift in the geopolitical landscape in the past few years is central to defining the emerging markets (EM) investment opportunity set going forward.
The new reality is that many emerging economies have become more resilient for a host of reasons, and they no longer simply ride on the coattails of developed market growth and policies. However, these positive developments are juxtaposed against a fresh set of challenges, namely increasingly procyclical liquidity provision by market makers, a rising propensity for populist policies and a temptation to rely on currency depreciation as a substitute for much-needed structural reforms.
Weighing up these new realities with the sell-off in EM assets so far this year, we think value and risks are now better aligned. However, the long list of risks facing EM still argues for a highly differentiated stance, as market illiquidity has the capacity to magnify the impact of any shock on prices.
The long-term case for emerging markets
In addition to higher yields than their DM counterparts, three trends underpin the secular case for investing in emerging markets across global business cycles.
- EM economies have climbed up the development and ratings scales over the past few decades, lessening significantly their dependence on foreign borrowing.
- Most have moved to floating exchange rates, which serve as buffers against external financing shocks. As a result, growth in these countries is more insulated from shocks such as an unanticipated tightening in U.S. monetary policy.
- And crucially, with many having established track records as credible inflation targeters, most EM central banks no longer have to embark on procyclical monetary policy tightening in the face of large exchange rate depreciations. Domestic bond markets are accordingly better insulated, which in turn gives many governments recourse to counter-cyclical fiscal policies to stabilize growth and preserve debt payment capacity.
After 30 months of Federal Reserve tightening and 18 months of the administration of U.S. President Donald J. Trump, we are also encouraged by several recent developments.
First, the glacial pace of monetary policy normalization in the developed economies looks likely to continue due to aging demographics, high debt levels and weak productivity growth. Low equilibrium interest rates are an important anchor for EM local and external debt prices. So is the dearth of inflation pressure globally despite ongoing labor market improvements.
Second, having typically been “condition takers,” emerging markets are closer to being condition makers than at any point in modern times. In particular, this reflects China’s rising share of the global economy ‒ witness the reverberations across global markets from China’s periodic bouts of growth uncertainty over the past few years. Going forward, weak EM growth is likely to influence policy decisions by developed economies.
And third, the sensitivity of EM economic growth to U.S. interest rates and the dollar should lessen given lower external borrowing needs, the relative lack of external borrowing in dollars specifically, and reduced dependence on commodity exports. While Argentina and Turkey are noteworthy exceptions, most major EM economies have been substantially liberated from “original sin” ‒ their governments’ inability to borrow in their own currency.
The complexities of the new EM reality
These constructive trends have nuances and repercussions that we think must also be factored into investment decisions.
While liberation from original sin mitigates the need to tighten policy pro-cyclically into externally driven shocks, it also means that the burden of any requisite adjustments will fall disproportionately on exchange rates rather than domestic interest rates. As a result, exchange rate depreciation, particularly in countries with credible inflation-targeting regimes, acts as a crutch for growth.
Moreover, weaker potential growth, the counterpart to lower equilibrium interest rates, has created fertile ground for populism. Countries lacking robust institutions are more likely to adopt populist policies that ultimately hinder growth. So while risks may be lower on average for emerging markets, this left-tail risk remains high.
Meanwhile, though the less-liquid nature of emerging markets has always demanded extra care in scaling positions, the liquidity risk premium for EM assets may be more procyclical than in the past. Regulatory changes have reduced the intermediation capacity of traditional liquidity providers, while new, computer-driven intermediaries with negligible capital buffers are prone to withdraw from the market when volatility
Finally, the success of emerging markets in transitioning to floating exchange rates, combined with the low-growth environment, has indirectly led to a proliferation of nationalist, protectionist policies in the developed economies. When exchange rates bear the burden of domestic macro adjustments in a higher global growth environment, reslicing a large growth pie through currency movements is less perceptible.
But with growth potential now lower, political sensitivities to exchange-rate-driven adjustments are higher. This raises the risk of a feedback loop between EM currency depreciations and DM political responses, which include tariffs and other trade measures designed to protect their shares of a shrunken pie. This loop is difficult to break because EM currencies typically weaken as growth is threatened.
The bottom line
From an investment perspective, we can draw several conclusions relevant to both short- and long-term horizons.
- Traditional EM risks, defined by vulnerability to external financing shocks and volatility of GDP growth, have gone down. So has the traditional threat to emerging markets: sharp, unanticipated changes in developed economy monetary policies.
- Despite lower potential growth and lower equilibrium interest rates in developed economies, absolute returns on average for emerging markets may be no lower than in the past.
- Liquidity disruptions are likely to occur more frequently, requiring careful attention to the size of illiquid exposures in periods of low volatility. Active managers have the ability to position assets to exploit valuation discounts following from liquidity-driven overshoots.
- Lower potential growth means greater propensity for populist outcomes. Higher spreads will likely need to compensate investors in part for this risk.
- The EM asset hierarchy has been flipped on its head. In the past, EM countries defended exchange rate pegs. Stress was borne first by local interest rates rising sharply and then through wider external debt spreads as currency pegs came under pressure. Now, currencies are the primary buffer, which mitigates the fallout on EM debt. However, this may imply larger, but less disruptive, currency adjustments than in the
While we think EM currencies are now attractively valued, investors need to scale their exposures carefully given the persistent uncertainties around U.S. trade and fiscal policies. But the more important point is that currencies are working to insulate EM growth. Ultimately, sustained growth is the best immunization against populism.
We see the latest sell-off in external and local EM debt as having rebalanced valuations and near-term risks. We believe any contagion from the weaker credits to the stronger credits in emerging markets should offer selective buying opportunities for the remainder of this year and into 2019.
For more on emerging markets, please see the Viewpoint, Investing in China: Evolving Opportunities.