By Matthias Busuttil
Emerging markets opened the year strongly on the back of a positive global growth outlook, low and stable inflation, rising commodity prices and, more importantly, a weak dollar. Emerging market (EM) currencies appreciated against the dollar, EM equities rallied, while EM monetary authorities were on the path of cutting policy rates thus sustaining the momentum in the local currency bond market performance at least up until the end of the first quarter.
However, the tables soon started to turn as the trade rhetoric out of the US administration has significantly disturbed the outlook on global trade. At the same time, the increasing expectations of the effects of fiscal stimulus on the economy are underpinning the tightening monetary policy stance in the US. Despite the weaker-than-expected jobs report for the month of April, average hourly earnings and unemployment have been on a positive trajectory for several months, while inflation has been slowly approaching the 2% target level. US treasury issuance has accelerated during the first quarter, increasing the total amount of US government debt by circa USD 370 billion by the end of April, while the securities held by the Federal Reserve, in part acquired under its quantitative easing programmes, have reduced by close to USD 80 billion.
All these factors have been pointing towards a higher yield curve in the US and a stronger dollar. In fact the 10-year treasury yield has been trading towards the 3% level for the first time since 2014 while the US Dollar index has appreciated by 4% since mid-April.
The heat is now on emerging economies with a number of countries risking falling into a recession. The gains on EM local currencies, equities and bonds since the start of the year have quickly been wiped out as a result of the rapid reversion in the weakness of the dollar and the rising US yield curve.
In order to better understand the linkage between the two markets, one needs to look at the reliance of emerging economies on external financing. EM sovereigns as well as corporations have resorted to developed markets to raise capital by issuing debt in US dollars or euro, thereby benefiting from lower financing costs and a larger pool of capital. Secondly, emerging economies typically rely on capital flows from developed economies to finance current account deficits or fiscal deficits.
The pressure on emerging economies starts to build when the opportunity cost for foreign investors, in this case the expected returns in US dollar, rises and the reduced attractiveness of emerging markets fuels capital outflows back to developed markets. This results in greater challenges for EM sovereigns to finance the "twin deficits".
In the current environment, the situation was exacerbated further with the ensuing depreciation in EM currencies. As the dollar strengthens, the debt obligations of EM sovereigns and corporations become more expensive to service in local currency terms. This therefore leads to significant pressures on public finances and the operational results of corporations resulting in higher risks of insolvency.
A number of EM monetary authorities have reversed their easing stance and are resorting to rate hikes in an attempt to shore up their currencies and to combat imported inflation. Argentina, for instance, has raised interest rates from 27.2% to 40% in a few days. Turkey is also expected to raise rates further weeks after it raised its key rate from 12.75% to 13.50% in April.
The effects of an increase in opportunity cost combined with EM currency weakness and capital outflows is evident in the rapid unwinding of carry strategies whereby investors sought to benefit from borrowing at a lower cost in hard currency, say in dollars, and buy the higher yielding EM investments. The Bloomberg EM carry trade index shows an accelerated decline from a gain of 4% during the first month of the year all the way down to negative 1.9% since the start of the year.
While upcoming elections in a number of Latin-American countries and the trade war talk between US and China set out a volatile outlook for emerging markets, the widening yield spreads of hard currency EM debt may present opportunities to active investors in identifying issuers that have cheapened to unwarranted levels as a result of blanket selling by index funds and passive strategists. Such opportunities may lie with entities that have offsetting assets or income streams in hard currency that provide a hedge to their financial position and potentially reduces their sensitivity to a deteriorating credit environment across emerging markets.
Moreover, over time certain emerging countries have adjusted their exchange rate policies and foreign currency reserves and improved current account deficits in order to reduce the financial dependency on foreign capital and to enhance their financial stability in these economic conditions.
The information presented in this commentary is solely provided for informational purposes and is not to be interpreted as investment advice, or to be used or considered as an offer or a solicitation to sell/buy or subscribe for any financial instruments, nor to constitute any advice or recommendation with respect to such financial instruments. Curmi and Partners Ltd. is a member of the Malta Stock Exchange, and is licensed by the MFSA to conduct investment services business.