Volatility is back – but not all emerging markets are exposed

Written By: Urban Larson Product Specialist Standish

Urban Larson of Standish looks at the volatility affecting emerging markets bonds and currencies. He examines the factors contributing to the volatility, and its distinct impact on individual markets

In recent weeks, volatility has returned to emerging markets bonds and currencies, with headwinds coming from both broader trends and headlines generated by individual countries. The gradual removal of quantitative easing in the US makes for a less supportive backdrop for emerging markets financial assets. Additionally the ongoing rebalancing of the Chinese economy is exposing financial risks in that country and reducing demand for commodities. Political and economic turmoil in a handful of countries, notably Argentina, Turkey and Ukraine, has made investors fear potential contagion.

Emerging markets generally retain considerable policy flexibility and remain less indebted than developed markets. Nonetheless, it is clear that those emerging markets countries with weaker economic fundamentals and, therefore, greater dependence on global liquidity will face greater challenges in the coming months as investors demand a higher premium to hold their securities. The turmoil in the markets has led to more attractive valuations across both US dollar denominated and local currency denominated emerging markets debt. It is crucial, however, to differentiate between credits as not all emerging markets are equally well placed in the current environment. The asset class has continued to see outflows and we do expect some continued volatility.

US rates should continue rising but at a slower pace
Monetary conditions in the US continue to be a key driver of market sentiment, although the US Federal Reserve accompanied its first reductions in quantitative easing with an accommodative statement and appears likely to continue to move gradually. The change in the direction of US monetary policy has led to investor repositioning that has hurt emerging markets as the prospect of higher US rates has led to an increase in the risk premium required of emerging markets assets. We expect the yield on the US 10-year Treasuries to rise at a gentler pace than seen in last year’s sell-off, although it is currently on the expensive end of our estimated fair value range. By the end of the fourth quarter, we expect the Fed to end its purchases of US Treasuries and mortgages. We believe that this will be consistent with an increase in 10-year US Treasury yields to a range between 3.25% and 3.75% by year end.

Improving growth in the developed world is positive for emerging countries
Higher rates in the US are reflective of an improving growth outlook. The incoming US economic data is consistent with strengthening private demand, which bodes well for growth in the first half of 2014. Recent data suggests that consumer spending is running at a 2.5% pace, while new orders for non-defence capital goods point toward growth in business investment of between 6% and 8%. We expect this momentum to carry forward into the first half of 2014; especially as the improving labour market and wage increases begin to benefit US households. Economic data from other developed markets also shows an improving growth outlook. Better growth in the developed world bodes well for emerging market exports, and should be supportive of emerging markets growth and credit quality. In the short term, the increased trade flows should lead to balance of payments improvements for many exporting countries, as external demand grows more quickly than internal demand. Longer term, better growth in the US and elsewhere should lead to higher foreign direct investment (FDI) for emerging markets.

China continues to grow and has the resources to contain domestic financial risks
China’s economy continues to expand at a healthy 7% rate, a more sustainable pace than the breakneck growth of past years. In this context, market participants have been concerned over the possibility of defaults in the trust loan sector, which has been a key investment vehicle for locals in search of higher returns than those offered by the banking sector. A high-profile potential default1 was recently averted, while the People’s Bank of China has injected short-term liquidity to address a spike in short-term interest rates. We continue to expect the government to slow China’s debt growth and contain financial risks, while delivering sustainable growth. Although the risk of trust defaults remains, China’s overall debt burden is still manageable and China has the ability to take decisive measures to arrest the rising leverage. Near-term risks of defaults and tighter liquidity have been built into our growth forecast for China of 7.2%. While weaker demand for commodities from China hurts the raw materials exporters among emerging markets, lower commodities prices ought to reduce costs and lower inflationary pressures for emerging market exporters of manufactured goods.

The troubles of a handful of countries are not indicative of a broader emerging markets crisis
Anticipation of lower global liquidity has helped highlight the most fragile emerging markets without hurting the sound fundamentals of most countries in the asset class. Argentina has garnered headlines due to a sharp fall in the Argentine peso as the country’s heterodox policy model shows signs of age, but it is very much sui generis and its bonds are among the most speculative in the emerging markets. Perennially-troubled Ukraine is also very much a speculative investment and the current political turmoil further stresses the country’s already weak fundamentals without setting much of a precedent for other emerging markets. Investment grade-rated Turkey is more widely held by investors. Market concerns over the country’s current account deficit have been compounded by unclear monetary policy and an outbreak of political tension due to a major corruption scandal. This has led to significant currency weakness that the Turkish Central Bank has struggled to contain. We have been underweight all three of these markets in all of our strategies for some time. Despite the troubles of a handful of countries, most emerging markets remain considerably less indebted than developed markets and retain the ability to make adjustments in both fiscal and monetary policy in response to market pressures, as many have already begun to do. With the development of deep and broad local currency debt markets, emerging markets public sector finances are significantly less vulnerable to currency depreciation than in the past, when emerging markets borrowing was largely in US dollars. For this reason, we do not expect currency volatility to trigger a balance of payments crisis in the emerging markets, as it might have in the past. In these circumstances the exchange rate is free to absorb the market volatility that has previously been known to bring down entire economies.

Valuations are attractive but differentiation is key
The recent sell-off has brought valuations to a level that already reflects an increased level of risk. Spreads on US dollar-denominated emerging markets debt are now higher than spreads on US corporate bonds, although historically they have been lower. Similarly the spread on US dollar corporate emerging markets debt is now higher than that on US high yield, although the former is rated investment grade. In local currency debt, the benchmark’s over 7% yield is above its long-term average, and is particularly attractive given the strong quality of the asset class (rated BBB+). Additionally, most emerging markets currencies are close to or below their long-term fair value.

We expect market participants to continue differentiating between countries, credits and currencies even after the current volatility subsides. We are more positive on those countries that have sound fundamentals and are better placed to directly benefit from stronger growth in the US and other developed markets. We remain cautious on the outlook for those countries that have less flexibility in fiscal and monetary policy. We have a small underweight in duration across all of our portfolios. In US dollar debt we see particular value in quasi-sovereign and corporate issues from countries with positive fundamentals. In local currency bonds we are overweight Latin American rates at the expense of duration exposure in Asia and Central Eastern Europe, Middle East and Africa (CEEMEA), and are overweight select currencies which are the best-placed to benefit from global recovery.

Important information

The value of investments and the income from them is not guaranteed and can fall as well as rise due to stock market and currency movements. When your client sells their investment they may get back less than they originally invested.

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1. $500 million Credit equals Gold No. 1 investment vehicle