Emerging Markets Watch – Differentiation still the dominant theme

by: Arjen van Dijkhuizen , Nora Neuteboom

  • Impact 2018 market turmoil on EMs comparable to taper tantrum
  • … with some generic factors affecting the whole EM asset class
  • However, differentiation is still more important than general contagion
  • Differentiation is shaped by country-specific fundamentals / vulnerabilities,
  • … while exposure to trade conflicts impacts stock market performance
  • We still do not expect a ‘general EM crisis’ …,
  • … a view we feel is supported by recent market corrections
181003-EM-Watch.pdf (646 KB)

Impact of market turmoil on EM asset class comparable to taper tantrum …

In the course of this year, emerging markets (EMs) have been feeling the heat from a rise in risk aversion amongst investors, feeding portfolio outflows from EMs and adding pressure on EM currencies, interest rates and stock markets.  If we look at the EM asset class as a whole, it is fair to say that the effects of this year’s market turbulence on EMs has been more or less comparable to the impact from the taper tantrum in 2013-14. If we for instance look at the general EM-FX index or at EM FX volatility, the overall impact this year is quite comparable to what happened during the corresponding period in 2013-early 2014. These indices also show that market sentiment seems to have stabilised in recent weeks. The overall EMFX index has recovered a bit while EM FX volatility has dropped materially, although currencies such as the Indian rupee and the Indonesian rupiah have weakened further reflecting country-specific issues. IIF data also point to a resumption of portfolio flows into EMs in recent weeks.

… with a couple of generic factors at play

There are several generic factors that have impacted EMs as an asset class this year.

Most of these factors have the US as common factor:

1)     The ongoing Fed rate hike path and rising market rates in the US. The fact that risk free rates at home are rising is softening the incentive for investors searching for yield to invest in a riskier asset class such as EMs.

2)     A related factor has been general dollar strength, stemming from US macro policies. Coupled with a rise of EM USD denominated debt over the past years, this has added to EM’s vulnerability to currency depreciation and made investors more wary.

3)     Another key factor – not an issue during the taper tantrum – has been the escalation of trade tensions between the world’s major powers, particularly between the US and China. Financial markets have been unnerved by the stepping up of import tariffs, the uncertainty how far such a trade war may go and the potential economic impact. Related uncertainties on the trade front from negotiations on NAFTA seem to have faded, but tensions between the US and the EU and Brexit related risks remain.

4)     Contagion from Turkey and Argentina: distress in these key EMs seems to have impacted investor sentiment regarding the broader EM asset class (see boxes).

5)     (Geo)political issues and sanction threats: currency weakness in Turkey, South Africa and Russia has been accelerated by the US threatening with or imposing sanctions.




BOX 1 – Argentina

In April this year, the peso plunged due to investor concern about the government’s ability to control inflation against the background of higher interest rates in the U.S and a strengthening US dollar. Argentina has high current account and fiscal deficits, as well as substantial foreign debt levels. The central bank took action and hiked interest rates in the past months from 27.25% to a current level of 60%. The depreciation made Argentina’s external debt (60% of GDP) more expensive, prompting Argentina to turn to the IMF for a USD 50bn Stand-by agreement. Meanwhile, the pain facing the economy continues to mount. Political uncertainty will increase as the country holds elections in 2019. These are still too far away to make a meaningful prediction, but it is clear that, after a flying start, the current government of president Macri has lost much of its lustre. Social unrest was already on the rise, with strikes and protests the order of the day.  Higher interest rates and more fiscal adjustments will have an adverse impact on growth. Accordingly, we have further reduced our growth forecast for 2018 to 1%. The outlook for 2019 is extremely uncertain, but we still assume a pick-up in growth, albeit at an extremely meagre rate. (For more information see: LatAm Watch: Recovery falters). 

However, differentiation still the dominant investor theme

Although the EM asset class as a whole has been hit by the generic factors mentioned above, we still would like to highlight that differentiation within this very heterogeneous asset class has again proven to be an even more important investor theme than general contagion. Although this year many EM currencies have been hit more than during the taper tantrum, markets still seem to be more selective now and have clearly singled out Argentina and Turkey as the weakest links (see chart). True, the USD dollar has also appreciated significantly versus other EM currencies, but the difference with the Turkish lira and Argentina peso is striking.



BOX 2 – Turkey

For some time, there have been concerns about overheating of the economy, as economic growth has been above trend for the past few years (7.4% in 2017). Inflation is high (almost 18%) and the current account deficit has continued to deteriorate (2018 estimate: 6.5% of GDP, although we see a clear downward correction already taking place). The larger current account deficit has been accompanied by a rise in non-resident portfolio inflows, which increased Turkey’s reliance on volatile short-term capital inflows. Tightening by the Fed, higher energy prices and disappointing growth in the eurozone weighed on Turkey’s external position. In the latest round of presidential elections, Erdoğan consolidated his power and further weakened the independence of the central bank. The lira depreciation accelerated sharply on 10 August, when a US-Turkey diplomatic spat on the extradition of a U.S. pastor escalated. Since the beginning of the year the lira has depreciated 37% against the dollar and 34% against the euro. As the US is the largest foreign holder of Turkish bonds (over 30% according to IIF), the question arose whether Turkey would still be able to finance its financing requirements of USD 220bn. On 13 September the central bank (finally) took action and  increased rates by 625bp to 24%. Furthermore, the Minister of Finance Albayrak presented the New Economy Plan that announced several much needed structural reforms. This helped the lira to partly recover from low levels. As explained in our Turkey Watch: TRY to recover, we still believe that the government will be able to repay its short-term financial obligations (short-term debt and principle payments). The private sector – not the government (as is the case for Argentina) – is the largest foreign currency borrower. We expect that Turkey will explore all other option before knocking on the IMF’s door. Lower credit growth and a weaker currency will make it difficult for certain companies to fulfill their (external) debt obligations. In light of these factors, we expect the Turkish economy face a sharp contraction (-3%) in 2019 (for our forecasts see: Turkey Watch: The crisis: a long time coming).


Differentiation shaped by country specific fundamentals and vulnerabilities

This discrimination is not a coincidence. Our view is that differences in fundamentals do matter and explain why some EMs are hurt more than others. In our view, the following factors have been and still are particularly relevant in the current juncture:

a)     External indebtedness and the share of debt denominated in USD (not only of the government, but also of banks, corporates and households).

b)     Current account deficits/external financing requirements.

c)     Dependence on commodity imports (rising oil prices, for instance, triggered a rise of current account deficits in oil importers such as Turkey or India).

d)     Specific (geo)political risks (e.g. China, Turkey and South Africa – tensions with US)

e)     Resilience of banking sector (also in relation to a)

f)      Pro-active policy measures taken to reduce vulnerabilities.


The table below shows how EMs rank on some of these fundamentals. Already in early 2018, before sentiment versus EMs started to weaken materially, we used this table to flag Argentina and Turkey as the most vulnerable countries to an increase in risk aversion among investors. The table illustrates that other key EMs such as Brazil, Chile, Indonesia and South Africa have external and/or domestic debt-related vulnerabilities as well.


Trade tensions have played a role as well

From the above paragraphs we can conclude that countries with substantial external imbalances and/or countries that are lagging in terms of pro-active policy measures typically have been the most impacted by the rise in risk aversion. However, that is not the full story. If we look for instance at this year’s stock market performance of key EMs (see chart above), we can see that some more creditworthy countries, particularly China, have been impacted by the escalation of trade tensions (mainly between the US and China). Moreover, some other emerging countries whose growth models rely strongly on global supply chains (for instance in Asia) also show subdued stock market performance so far this year, although more factors will play a role in explaining this of course. This trade tension factor did not play a role during the taper tantrum in 2013-14.

Why we still do not expect a ‘general EM crisis’

In our EM Watch last May, EM Capital flows – Singling out the weakest links, we explained why we did not belong to the Doomsday camp in the sense that we did not expect the EM turmoil seen on financial markets to translate into broad balance of payment problems and/or widespread recessions in EMs. We still hold this view and recent market developments lend support to it as well. Our view is based on a couple of factors that provide a cushion to EMs:

1)     Solid growth in advanced economies (and in Asia) is supporting EM exports, while currency depreciations make several EMs more competitive. For many EMs, we expect these effects to offset the drags from rising interest rates and a tightening of financial conditions.

2)     Moreover, currency depreciations will, together with policy measures and in some cases lower growth, contribute to external adjustment and keep external deficits under control. In Turkey and Argentina, for instance, external deficits are coming down rapidly. In several other key EMs (e.g. Brazil, India, Indonesia, South Africa), current account deficits have risen but remain at quite manageable levels – also in comparison to the taper tantrum episode.

3)     Related to the first point, commodities are generally holding up nicely and we expect them to continue to do so. That is quite a difference with the taper tantrum period, that took place in the middle of a sharp bust in commodity prices. That is on balance supportive for EMs, with a few exceptions such as Turkey and India.

4)     While trade tensions between the US and China have escalated in recent months (with a total of USD 360 bn of bilateral exports of both countries now subject to 5-25% import tariffs), risks of a full-blown global trade war have fallen. Moreover, the latest measures taken by the US were watered down somewhat (import tariff lowered from 25% to 10%, at least until 1 January 2019) and there still is wiggle room. Markets on balance reacted positively to the latest measures, illustrating that a lot of bad news was already priced in.

5)     What is more, China has pro-actively stepped up fiscal stimulus (see our latest China Watch, The USD 200bn question answered) and tweaked – not abandoned – its financial deleveraging campaign a bit, to offset potential downside risks from the trade and investment conflict with the US. In fact, although in our base scenario we expect China’s gradual slowdown to continue, we also see upside risks to our growth forecasts for China. A related point is the action taken by the PBoC to stem the strong slide of the yuan versus US dollar in June/July. This temporary yuan weakness contributed to pressures on EM currencies, but after the PBoC stepped in the yuan has stabilised. That has brought relief on this front.

6)     Beyond China, policy makers in many other EMs have taken pro-active measures to reduce vulnerabilities. Policy rate hikes have been common in many EMs in recent months, and some governments (e.g. in India and Indonesia) have taken other measures as well to keep the rise of the current account deficit in check.

7)     In the EMs most impacted by the market turmoil, Turkey and Argentina, we see some signs of stabilisation (see boxes). In Turkey, the latest rate hike of the CBRT was much stronger than markets had expected, while an economic adjustment program has been announced. Argentina has sought access to an IMF Stand-by arrangement, with an economic program attached that should help the country getting back on a stronger footing.

8)     Our FX strategist still  expects general dollar strength to fade out in late 2018. Note that changing EM valuations will also impact investors’ risk/return trade-off (obviously, that would not give sufficient comfort should overall sentiment deteriorate further).

Impact on growth forecasts

While we still do not expect a general EM crisis (in the sense of broad balance of payment problems and/or widespread recessions), we have downgraded several of our EM growth forecasts in the course of this year for those countries were the fall-out from the EM turbulence was substantial. For Argentina for instance, we have sharply reduced our 2018 and 2019 growth forecasts (to -1.5% and 1.5%, compared to 3.5% and 3% in February 2018). For Turkey, we have slashed our 2019 growth forecast to -3% (from 4% in February 2018). We have also lowered our growth forecasts for other countries affected by the market turbulence, for instance for Brazil, Indonesia, Malaysia and Mexico. Still, as growth in emerging Asia is holding up well, the overall impact on EM growth is quite limited. We now expect EM growth at 4.7% in 2018 (down from 4.8% in February), falling – but not collapsing – to 4.3% in 2019 (February 2018: 4.7%).

In conclusion

EMs have certainly been hit by market turmoil this year, with some generic factors affecting the whole EM asset class. Many EM currencies have weakened substantially and this year’s turmoil is comparable to the corrections seen during the taper tantrum, with escalating trade tensions being an additional negative factor for EMs. However, we are still of the view that differentiation is still a more important investor theme than general contagion. Market developments show that differentiation is shaped by country-specific fundamentals and vulnerabilities. We have lowered our EM growth forecasts for 2018 and now expect EM growth to slow, but not collapse, in 2019. Given that there are still quite some supportive factors for EMs, we still do not expect a ‘ general EM crisis’ in the form of broad balance of payment problems and/or widespread recessions/contractions in EMs.