Emerging markets have outperformed global credit markets since the turmoil began in August. But the bet that the asset class will continue to be a safe haven seems shakier by the day.
The spread for the benchmark JPMorgan Emerging Markets Bond Index Plus has widened out to its highest level in several years, hovering around 300 basis points over US Treasuries. Admittedly, what is happening to the Embi+ is less important than it once was. External debt markets are shrinking and account for less than 20% of total debt outstanding in the emerging markets universe, according to the Bank for International Settlements.
Instead the fortunes of the asset class are more closely intertwined with the local-currency markets, which account for more than $5.8 trillion of outstanding marketable securities. For the past few years, the local-currency markets have provided a big source of alpha for emerging markets investors. During the past four years, local-currency bonds provided an annualized return of 17.04% in dollar terms, according to JPMorgan’s GBI-EM Global Diversified index. In the 12 months up to March 19, these assets yielded a return of 19.1% compared with 4.9% from the Embi+.
Tellingly, their performance has tailed off dramatically this year, yielding a return of only 3.4% up to mid-March, although that’s much better than the 0.5% return found in external debt.
Despite the relative calm of the emerging markets, they can no longer escape the consequences of the credit crunch. Investors are getting jittery about all asset classes, including emerging markets. Moreover, the macroeconomic environment for these countries is less supportive than it once was. There is concern about a prolonged US recession. In many of the bigger emerging markets, inflation is a looming threat, if not already an actual one – especially in the Bric countries of Brazil, Russia, India and China. In all four nations, policymakers are grappling with the dilemma of whether or not to raise interest rates and implement other measures to curb liquidity.
In South Africa, analysts are predicting CPIX inflation to peak at 10% in March and to average 9% for 2008. High oil prices, increases in food and electricity prices, and a weaker rand are all contributing to the deteriorating outlook. Throw into the mix a current account deficit that reached 7.5% in the fourth quarter (down from a 25-year high of 8.1% in the third quarter), subdued domestic demand, weakening growth and political uncertainty about the composition of the next government and it’s little wonder that South Africa is the worst performer in the GBI-EM index, with a year-to-date return of –15.5% in dollar terms.
In contrast, the best performer in the index, Chile, is yielding a return of 18.7% over the same period. Sustaining the rally in Chile is relatively high commodity prices. But what happens when the commodity party comes to an end? Prices have already begun to over-correct as speculators trade in and out of commodities in search of a quick buck.
The global slowdown and a continuation of the massive deleveraging that is taking place in the financial system will undermine commodity prices and will hit certain emerging markets, such as Brazil and Russia, hard. At least these and other developing countries have saved well during the boom years and can call on record international reserves to dull the pain.
The emerging local-currency markets are no longer a one-way bet. The weak US dollar means that gains are still possible from FX exposure rather than credit exposure. But volatility will remain high.