Emerging Market Debt: An End To The Agony? by Jim Cielinski, Columbia Threadneedle Investments
- Capitulation by many EMD investors has created opportunities in many of the more resilient countries.
- We favor countries moving down the reform path and where there is significant impetus to reign in excessive government spending.
- Valuations have reached the extremes that allow a selective approach to EM to now represent a key part of an income-oriented portfolio.
Emerging markets (EMs) have endured a miserable year. Slowing Chinese growth, collapsing commodity prices, rising indebtedness and geopolitical turmoil have all taken their toll on fundamentals. The worsening EM story has, in turn, had a negative impact on capital flows, impacting performance both in absolute terms and relative to developed markets.
More recently, China’s devaluation has led to fears that deflation could be exported to the rest of the world. The haphazard nature of China’s policy response to the economic downturn has weakened investor resolve that Chinese authorities can engineer a “good” outcome. The problems do not end there. The Federal Reserve is stating a desire to tighten policy, prompting concerns that a continued rise in the U.S. dollar will undermine EM local returns.
Unsurprisingly, sentiment toward emerging markets has soured. The above trends are self-reinforcing, prompting many to call for EM to enter a protracted period of weakness. Given all the uncertainties, should investors simply ignore EMD altogether, or might a more selective approach to EMs produce better results?
It is far too late in the cycle to “give up” on emerging markets
Abandoning EMD altogether is akin to throwing the baby out with the bath water. The adjustment in EM assets is hardly new, and underperformance has been marked since at least 2012. Consider Brazil — a constant source of discouraging news. Brazilian equities, as measured by the Ibovespa, are down by 36% over the five years ending September 30 in local terms. For a U.S. dollar investor, however, depreciation of the Brazilian real has pushed the return to -71.7% over the period. Local rates in Brazil have risen to over 15%. Other markets — in USD terms — have also posted deeply negative returns. Russia, Ukraine, Turkey and Argentina have all endured periods of notable stress in the last 24 months.
Prices could, of course, move lower, but valuations suggest that EM challenges are well-recognized in the market. We fully expect a protracted period of emerging market economic weakness, but we are at a stage in the current cycle that demands a focus on dislocations and valuation. Many opportunities appear compelling. EM growth will be positive and will continue to exceed developed market growth (Exhibit 1), notwithstanding the risk of further downward growth revisions that have dominated this cycle (Exhibit 2). This is a recipe for further volatility, despite much-improved valuations.
Exhibit 1: IMF GDP growth forecast — advanced economies
Sources: Columbia Threadneedle Investments, IMF, 07/15
Exhibit 2: IMF GDP growth forecast — emerging economies
Sources: Columbia Threadneedle Investments, IMF, 07/15
It’s a different kind of EM crisis
In the 1990’s, EM stresses were amplified by fixed exchange-rate regimes. By pegging exchange rates to the U.S. dollar, countries sought to mitigate economic and trade volatility. As growth and inflation exceeded levels in the U.S., however, it also had the effect of encouraging borrowing at abnormally low real rates, most often in U.S. dollars. Initially, this credit creation provided a tailwind to growth. Much of it was unsustainable, however, and ultimately the excessive credit creation would leave sovereigns heavily indebted and exposed. As growth slowed, currencies would no longer be consistent with a manipulated fixed rate. External lenders would inevitably grow concerned about toxic levels of real borrowing and cut off funding. Defaults on external debt were a common “end-game.”
Today’s fundamentals are different. Few countries have fixed exchange-rate regimes and sovereigns have not recklessly ramped up leverage. The relief valve today is the exchange rate. Emerging market currencies have now fallen 34% from their peak levels of the post-crisis period and are trading at their lowest levels since 2007 in nominal terms. For dollar investors, this already qualifies as an “effective default” — losses not associated with a traditional “lack of payment” but rather with a debasement in currency. This explains why external debt returns (i.e., “hard currency”) have been respectable in the current cycle, although foreign exchange (FX) returns have been dire (Exhibit 3). The carnage has certainly not been limited to currency, however. Local rates in most markets have moved higher, in many cases sharply underperforming developed markets (Exhibit 4).
Exhibit 3: EM excess returns vs. EM FX (against US dollar)
Sources: Bloomberg, JPMorgan, Columbia Threadneedle Investments, 09/15
Exhibit 4: EM local rates
Sources: Macrobond, Columbia Threadneedle Investments, 09/15
It is fair to deem these types of returns as indicative of a modern-day EM crisis, but this crisis will have a different ending. Something must be done to break the self-reinforcing downtrend of weaker growth and falling currencies, which prompts further capital outflows and tighter domestic policies via higher interest rates. It will not be easy but there is hope on the horizon.
An emerging market rebound — in search of an elusive catalyst
There have been numerous false bottoms in EM over the last three years. Identifying a catalyst for a turnaround first requires an understanding of just how the mess was created. Overall EM growth is slowing materially, but GDP growth in the healthier EMs will remain positive — even excluding China. While Chinese GDP growth is indeed decelerating, we believe it is not likely to drop below 4.5%, as such an outcome would most likely require policymakers to sit on its hands and watch the economy implode. This is inconceivable given the significant foreign currency reserves and policy tools at their disposal. Real interest rates in China are still very high, and fiscal policy could be used to support growth.
Despite the glimmers of hope in China, the path for EM is rocky and there are simply no easy solutions for their ailments. Most emerging economies have lost their ability to set monetary and fiscal policy. China still occupies a position of “policy maker.” Other countries are “policy takers.” They cannot ease because their currencies are weak and inflation accelerating. They cannot tighten because real growth is stumbling. They cannot boost fiscal policy simply because most have already overspent. These countries will remain mere passengers on a policy train driven by the U.S. and China.
Currency debasement is an oft-recommended but highly inexact “solution” to export woes. Soft exports are only one part of the EM economic malaise. The degree of devaluation necessary to significantly spur export growth is unclear, especially in light of the meager response to the already large currency adjustments. The root of the problem is that global demand is soft. Developed market demand has downshifted, and there is simply not enough export demand to lift all emerging economies. Moreover,