The media has cast a bright spotlight on emerging markets (EMs), and sensationalist headlines have become the norm as EM fixed income, equities, and currencies have come under pressure. Timothy Ash, EM senior sovereign strategist at BlueBay Asset Management,1 probes beyond the headlines.
Q. Timothy, as someone who has lived through many EM crises over the last 25 years, what has gone wrong?
In EMs, it’s normal to go through cycles where people either love the asset class with a passion or hate it with a vengeance. The reality is often somewhere in between—things are never quite as good as the peaks in asset prices might suggest, but not as bad as the bottoms might indicate either.
At the start of the year, the EM fixed income cup appeared half full. Concerns over further Fed tightening, trade wars, and the return of a positive U.S. dollar were put to one side in the search for yield.
The message was that as long as growth, commodity prices, and China (aka global trade) remained positive, aggregate EMs could still live with the higher debt service costs associated with the positive U.S. dollar and rising U.S. rates.
This seemed logical until we suffered twin hits from initial policy errors in Argentina and continued policy failures in Turkey. The broader market weakness is a direct result of nervousness around these two countries.
Emerging market spreads widen
EMs were much in vogue early in the year, but the tide has turned.
Q. Can you elaborate on the circumstances in these two economies?
Both are large, liquid markets, and their combined troubles knocked the stuffing out of EMs, leaving the EM cup looking decidedly half empty.
Argentina had previously been viewed as a popular turnaround story, with $100B worth of international assets flowing into this trade over the past couple of years.
In April, investor nervousness surrounding local market investments and a positive U.S. dollar led to the unwinding of positions, leading to a sharp selloff in the Argentine peso. The government successfully turned to the International Monetary Fund (IMF) to secure financing and restore some stability in the market. However, during August, the government unexpectedly called for the IMF to bring forward planned credit payments, exerting further pressure on the peso amid conjecture that the true economic situation might be more precarious than previously believed and raising doubts regarding the government’s ability to deliver on IMF conditions ahead of elections in 2019.
International positioning was lighter in Turkey, but policy missteps proved a common factor for both countries.
The Turkish central bank failed to employ sound monetary policy by refusing to raise interest rates throughout July while the lira was selling off and inflation concerns were mounting. President Recep Tayyip Erdogan also made a series of uninspiring cabinet appointments, including putting his son-in-law in charge of a new Ministry of Treasury and Finance. International relations were further tarnished when the Turkish authorities refused to release an imprisoned American pastor. Ratings agencies downgraded their assessments of the market.
External investors’ confidence levels were severely rattled by this combination of troubles, and the Turkish currency lost roughly 40 percent of its value.
We still think that both economies can execute a turnaround by making the right policy choices, but their room for error is now very small.
Q. So where do EMs go from here? Are we facing a systemic crisis such as the Asian crisis?
Argentina and Turkey are specific, idiosyncratic cases, and we’re not sure that we can claim that EMs are inevitably heading for a systemic crisis comparable to that which took place in 1997–2002.
We see four key differences between 1997–2002 and today:
1. Liquid EM currencies are no longer pegged to the U.S. dollar. Today, EM economies have floating foreign exchange regimes so that currencies can adjust. This should allow current account deficits to shrink, and central banks are generally responding with orthodox policy.
2. As EM currencies adjust, pressures and concerns typically move to the credit universe, and to countries with a heavy weight of foreign currency-denominated debt. Yet aside from Barbados, which defaulted on its debt over the summer, there has not been a big EM credit event to take an EM selloff to the level perceived as a real crisis—even Argentina and Turkey are stabilising for now.
3. The willingness and ability to pay debt obligations partly reflect the fact that, despite concerns around trade wars, both global trade and real GDP growth are holding up well, both in developed and emerging economies. The IMF is still predicting EM real GDP growth in aggregate for 2018 of around 4.9 percent, slightly higher than in 2017.
4. Oil prices are holding up relatively well, anchoring at least one-third of EM credits across the Middle East, Commonwealth of Independent States, Latin America, and Africa.
Emerging markets currencies and oil price
EM currencies plunged but oil prices remained stable.
Source - BlueBay, Bloomberg
Q. Do you think there is a chance of further contagion in the asset class?
Although the possibility cannot be discounted, in our opinion, the probability has lessened recently.
The soft spots—Argentina and Turkey—both appear to have taken pragmatic steps to restore investor confidence. Turkey has raised rates to 24 percent, exceeding market expectations, in order to combat inflation. Argentina has utilised monetary and fiscal measures to combat high inflation and maintain economic viability, in particular by reaching an agreement with the IMF.
These measures should allow investors to focus on the strong fundamentals and attractive valuations of the asset class, limiting further downside and reducing contagion.
Having said that, there are still several important hurdles for EMs to tackle over the coming months which could contribute to uncertainty and volatility, including the uneasy trade relations between the U.S. and China and Brazil’s elections in October.
Q. Given the investment complexities inherent in the region, and the individual nature of each country, how does the BlueBay team approach assessing EM debt as an asset class?
We have a very well-resourced team of 33 individuals dedicated to this asset class, including portfolio managers, traders, macro strategists, and corporate analysts. They carry out on-the-ground research and survey a broad range of market participants—from business, market, and political stakeholders to trade unionists, policymakers, and other investment professionals. Additionally, we analyse policy and economic inputs, while taking into account each country’s unique history.
We essentially try to operate as “credit detectives,” layering region, country, and sector insights together with due diligence points using the approach described above.
To complement our fundamental views, we rely on specialist traders for unique insight into the technical factors that drive markets, improving our ability to manage risk.
Q. In terms of opportunity set, where do you see value in EMs right now?
The EM asset class comprises around 70 countries, all with different economic profiles with idiosyncratic drivers. We believe there are a number of positive bottom-up stories across our markets where policymakers are being proactive and the macroeconomic backdrop is improving. The reform story in South Africa, for instance, remains positive. The market is still seemingly giving the Cyril Ramaphosa administration time and backing to make land and pension reforms in the country.
Similarly, we are also positive on the recovering trajectory of Nigeria. It runs a current account surplus and, as an oil exporter, it benefits from the stability and recent spike higher in the oil price. Nigeria has slowly been normalising its currency policies, making it easier for investors and exporters to convert naira into U.S. dollars.
These are just two examples from a diverse opportunity set. Spreads have widened across EMs, but as always it’s important to understand the fundamentals for each country in order to isolate the positive stories from the deteriorating ones.
1 BlueBay Asset Management is one of Europe’s largest specialist active managers of fixed income with over $59.6 billion in assets under management in corporate and sovereign debt, rates, and foreign exchange (as of June 30, 2018). Its investment philosophy and approach focus on delivering absolute-style returns, with an emphasis on capital preservation. BlueBay is a wholly owned subsidiary of Royal Bank of Canada with full investment autonomy and substantial operational independence.
Non-U.S. Analyst Disclosure: Timothy Ash, an employee of BlueBay Asset Management, a wholly owned subsidiary of Royal Bank of Canada, contributed to the preparation of this publication. This individual is not registered with or qualified as research analysts with the U.S. Financial Industry Regulatory Authority (“FINRA”) and, since he is not an associated person of RBC Wealth Management, he may not be subject to FINRA Rule 2241 governing communications with subject companies, the making of public appearances, and the trading of securities in accounts held by research analysts.