Emerging markets: more weakness to come
A massive currency sell-off this week echoes the dark days of emerging-market crises, say bears. Analysts are resolutely underweight emerging market bonds and stocks, citing the legacy of the recent credit boom and the absence of structural reforms.
Once upon a time, investment consultants touted a volley of positive macro-economic statistics – declining foreign indebtedness, middle-class consumption prospects, under-levered corporates, monetary independence and strong balance-of-payments positions – to flog the emerging-market allocation story.
Since the summer of 2013, however, a bear market has taken root in emerging market (EM) credit and equities, as investors wake up to China’s rising corporate indebtedness and disorderly transition to a consumption-driven economy, as well as the declining growth of the Brics, more generally.
The Fed’s tapering tantrum was simply the catalyst, as investors reassessed slowing growth prospects – amid weak productivity, potential for credit expansion and declining return-on-invested-capital in the large EMs – say analysts. Meanwhile, policy blunders in Ukraine, Argentina and Venezuela bring back the old days of bad EM policies.
Since May, India, Indonesia, Brazil, South Africa and Turkey have endured painful nominal depreciation of the currencies to correct unsustainable current-account deficits while engineering a slowdown in domestic demand by tightening monetary and fiscal policies, with hikes in overnight money market and retail commodity prices.
|Source: BCA Research
However, the adjustment cycle continues. This year, foreign retail money has fled EM asset markets, with a synchronized FX sell-off in Turkey, Argentina and Russia, especially, with their respective currencies hitting record lows this week, imperiling already-challenged stock market returns for a traditionally unhedged investor base. According to fund-tracker EPFR, there was $25 billion of net outflows from EM bond funds, principally hard-currency assets, in 2013. Sentiment for EM equities and local currency for 2013 as a whole was much stronger than anticipated than in the summer, with a net positive inflow of $26 billion and $19 billion, respectively.
However, hard-currency sovereign credit, which has largely outperformed other EM assets thanks to decent public balance sheets, has come under pressure this year, the MSCI EM Index is down 2.6% year-to-date and the outlook for EM local currency credit is grim amid FX losses.
The question on everyone’s lips is when the bottom of the market will be reached. After all, stronger G7 growth and the eurozone calm gave bulls confidence last year that EMs, historically a high-beta and growth-sensitive asset class, could outperform in 2014 while the S&P 500 hit all-time highs.
What’s more, there have been no psychologically damaging sovereign debt defaults, a currency crisis, outside of Ukraine, that has decimated the ability of the banking system to provide credit to the real economy, or, outside of hard currency bonds, a wave of disruptive redemptions from real-money foreign investors. What’s more, the IIF expects capital flows to EMs to fall to a modest 3% on 2012 to just over $1 trillion.
BCA Research, however, is bearish on EM assets. In particular, the shop is bearish on EM equities, citing the fact the return on capital for listed non-financial EM corporates has fallen to a 12-year low; continued weakness in China’s growth prospects; the fact that falling productivity performance has reduced listed corporate profitability; and that the correlation between EM equity returns and G7 GDP growth is negative.
|Source: BCA Research
At the heart of the argument: policymakers in many EMs lack the leverage to tout the virtues of politically sensitive structural reforms to craft a new growth model, which centres on ensuring household income and corporate spending growth can be ensured by productivity growth, rather than credit- or commodity-fuelled expansion. The shop argues: “EM policymakers do not have the buy-in from their populations for pro-market reforms. EM populations consider the previous decade of growth wasted, with no improvements in the quality of governance.
“Therefore, lower and middle classes will reject pro-market reforms, which are always and everywhere painful, and will demand costly improvements to the quality their life first. Pro-market reforms and improving the quality of governance are not one and the same.”
It adds: “The former usually involve deregulation, cutting subsidies, opening up to international competition, and introducing labour flexibility, while the latter deal with rooting out corruption, investing in infrastructure, and spending more on healthcare and education.
“EM populations want the governance reforms before they are willing to endure pro-market reforms.”
It concludes: “Finally, investors hoping that the current problems in EM are temporary and that higher growth rates in developing countries justify exposure should remember an important fact: GDP growth does not correlate with equity returns.”
|Source: BCA Research
BCA is also bearish EM credit, suggesting weaker commodity prices and currencies make EM bonds expensive compared with US high yield. The continued weakness in EM growth suggests investors should also underweight credit, conclude Morgan Stanley analysts.
“Many corporate sectors in EM are heavily exposed to currency weakness, given the size of USD liabilities in a number of corporate sectors,” they say. “Indeed, overall, EM has a negative net foreign asset position in the private sector, which leaves exposure to FX weakness.
“This, on its own, has the potential to cause credit risk to rise as the markets reassess the prospect of state support for corporate sectors and the assumption of contingent liabilities. With currency weakness being primarily led by capital outflows, the associated weakness in growth could lead to a reassessment of fiscal health as well, if tax revenues come in below expectations.”
It concludes: “This, in our view, is the next stage in the cycle for EM. Credit risk in local currency bonds could prompt further pressure on EM exchange rates.”
Nevertheless, the following chart suggests the impact of a rising dollar on the debt-service capability of EM non-financial corporates is likely to be modest.