Batten Down the Hatches in Emerging Markets

The environment for emerging market stocks is poor and likely to get worst. Investors should recognize that the current storm may last a considerable amount of time and that it  inflict severe damage.

At the start of this year, there was, briefly, an illusion of blue skies ahead for investing in emerging markets. Global growth was expected to improve and surpass the United States. In emerging markets, growth prospects looked good in China, and recoveries in Brazil and Turkey, the two serious laggards of recent years, appeared to be firm. Commodity prices also were rising and the USD was slipping. All of this was setting the stage for capital inflows into emerging market stocks and a period of outperformance.

Unfortunately, the positive scenario suddenly unraveled when the coronavirus hit China and put a sudden stop to Chinese growth.

Today, the relevant indicators all point to sustained difficult conditions for emerging markets.

The US dollar is once again appreciating, as risk aversion around the world has caused capital to flee to safe assets like the dollar, the yen, the Swiss franc and gold. This has been particularly acute in emerging markets, with many countries seeing their currencies plummet. The MSCI Emerging Market Currency Index, which shows the value of all the currencies in this stock index relative to the dollar, has traded down to record lows, as shown in the chart below. Latin American currencies are in free-fall. This extends a trend started in 2012 and has happened in spite of massive intervention by central banks and large swap lines provided by the US Fed. Many emerging markets have participated in a massive yield-chasing “carry trade” over the past five years. We are now seeing this trade being unwound. At the same time, recent years have seen a marked increase in capital flight from domestic investors.

Risk aversion is on the rise. Emerging market stocks and bonds are “risk-on” assets that perform well when investors have increasing tolerance for risk and/or are induced by low expected returns in their domestic markets to seek higher returns abroad. This appetite for risk only persists if volatility is predictable, which had been the case until recent weeks.. We can measure risk appetite by the spreads that investors demand to invest in riskier assets. The spread between high-yield bonds  and US Treasuries, shown below in a chart rom Yardeni.com, is an accurate measure of this. We see that spreads have rocketed in recent weeks, despite the enormous liquidity being provided by the US Fed.

It is very difficult for emerging markets to perform well when commodity prices are weak. Falling commodity prices indicate both a  weak Chinese economy and deteriorating conditions for many of the emerging economies that rely on commodity exports. It also normally means declining US current account deficits and tight global liquidity. As the chart below shows, commodity prices have been taken a further notch down in a long-term declining trend started  in 2012. This week the CRB spot commodity index broke below the previous cycle low from 2016.

Low commodity prices and rising risk aversion are both contributing to very tight dollar liquidity and the persistent rise of the dollar. The chart below shows global liquidity as measured by central bank reserves held at the Fed plus US M2, and illustrates how tight these conditions have been in recent years. In recent months, the US Fed has recognized this, resuming quantitative easing and providing swap lines to foreign central banks.

Tight global liquidity, a rising dollar, falling commodity prices and heightened risk aversion translate into a very difficult environment for emerging economies. Just dealing with the coronavirus alone would already be an enormous challenge for the majority of emerging economies that don’t have the public health systems for preventive and active care and also don’t have the fiscal resources for alleviating economic losses. Unfortunately, many emerging economies will suffer additional challenges because the find themselves at record levels of indebtedness.

EM countries, as a whole, have increased debt levels dramatically in recent years. The chart below shows the increase in debt-to-GDP ratios for EM countries over the past five years.  This remarkable increase in debt levels across EM has occurred at a time of low growth and low investment. In the case of Latin America, debt increases have served only to finance interest and current payments and capital flight. Any increase in the ratio above 5% would be noteworthy. Only India, Russia and Thailand are below those levels. It may turn out that for Russia sanctions were a blessing in disguise.

External debt levels for many countries also are  at dangerous levels, as shown in the table below. Countries are considered to be overexposed to foreign credit when this ratio passes 30%. It should be noted that some of these ratios are understated, as debt issued offshore through subsidiairies is not included (eg., Petrobras issuing bonds in the Cayman Islands).

On the positive side, and looking forward to the reflation trade.

Not all is gloomy. Resilient EM countries will bounce back, particularly those that can implement financial repression to reduce debt levels. Asset prices in emerging markets are at very low levels. This is reflected in the value of most currencies, now well below fair value. We can see this in the chart below from Alpine Macro.

 

More importantly, the shift in the U.S. and Europe to “QE Infinity,” modern monetary theory and fiscal exuberance is likely to mark the beginning of a new inflationary cycle which will bring the dollar down and commodities up and trigger a new liquidity cycle supportive of EM assets.