Old assumptions on the traditional link between emerging market debt and the greenback are being challenged, writes Liam Spillane.
4 minute read
For investors, it can be tempting to rely on established relationships in markets. In the last decade, for instance, market rallies have often been a function of central bank stimulus, while sell-offs occurred when concerns became elevated that the policy environment would be less accommodating.
Historically, a strong correlation has existed between the US dollar and emerging markets. Investors have generally been able to rely on the following scenario: when the US dollar rose, trouble loomed for emerging equity and debt markets. A veritable Pandora’s box would be opened, consisting of some, or all, of the following: capital outflows, rising debt ratios, higher inflation and weaker domestic currencies creating a greater need for more restrictive monetary policies. When the dollar fell, the lid of the box would snap shut, and emerging equity and debt markets generally appreciated due to the attractive structural properties of developing nations and the resultant capital inflows.
As with all relationships, there is ebb and flow and factors driving assumed connections can fray or intensify
However, as with all relationships, there is ebb and flow and factors driving assumed connections can fray or intensify. While not seeking to call a long-lasting or permanent breakdown in the correlation between movements in the dollar and emerging markets, recent developments have, in our opinion, suggested a weakening of the hold that the former has over the latter.
Fed hits pause button
First, let’s look at the dominant one in the relationship. Up until the turn of the year, the US Federal Reserve (Fed) was on a determined path towards normalising monetary policy. But circumstances have changed as concerns about slowing economic growth globally have escalated. China’s growth of 6.6 per cent in 2018 was its lowest annual rate since 1990; Italy is in recession, while Germany is hovering just above one. Meanwhile, the Chinese-US trade dispute has shaved several tenths of percentage points (and counting) from global GDP growth and remains unresolved.
The Fed pressed the pause button on quantitative tightening, while the European Central Bank is unlikely to begin its own rate hiking cycle until 2020
Consequently, the Fed pressed the pause button on quantitative tightening, while the European Central Bank is unlikely to begin its own rate hiking cycle until 2020. Fears about a liquidity drought have been put aside, or at least postponed, and as a result fixed income asset classes are viewed more favourably with significant inflows into emerging market bonds already in 2019. China has also turned on the stimulus taps – with some estimates suggesting over eight trillion yuan (US$1 trillion) of credit being pumped into the financial system in the first three months of this year alone.1
Such an uncertain backdrop has stymied the dollar’s acceleration. In 2018, the dollar soared over most other developed and developing currencies. Strong economic growth and the resultant ‘US exceptionalism’ narrative was a key driving force, thanks in no small measure to the tax cuts enacted by the Trump administration in late 2017.
Yet this year the dollar’s fundamental backdrop has altered. Growth in the US is slowing (from 4.2 per cent annualised GDP growth in the second quarter of 2018 to 2.2 per cent in the fourth quarter). In addition, the dramatic tax-cutting boost is largely played out, rate hikes are on hold and both the fiscal and current account deficits are set to rise.
Thanks, in part, to the US exceptionalism narrative, global investors poured money into US asset markets, contributing to the dollar’s current overvaluation. Given this has occurred at a time when hedging costs have become elevated, a more balanced outlook seems sensible.
Another slow-burning development has been some (or potential) challenge to the dollar’s predominant safe-haven status. A worsening fiscal position, Trump’s tax-cut giveaway, and China’s noticeable and recent distaste for US Treasuries have all conspired to dampen demand.
It may constrain further dollar strength and afford emerging-market currencies much-needed stability
These factors may not trigger a dollar bear market and should be tempered with a recognition of the currency’s historic defensive characteristics, as well as its abnormally high carry relative to G10 currencies. But it may constrain further dollar strength and afford emerging-market currencies much-needed stability, particularly with developed-market bond yields remaining at low levels. While Germany and Japan represent extreme cases, with negligible nominal and negative real yields, the yields on offer in emerging markets are, superficially at least, more attractive.
EMs finding their feet
In contrast to the question marks hanging over the developed world, emerging markets have made notable strides with economic and financial reform in recent years. While by no means immune to the whims of the US sentiment and the dollar, they are far more resilient than they once were. Fundamentals are stable – even moderately improved in some cases – and economic growth rates are solid. Debt-to-GDP ratios have fallen, and current-account balances are generally rising (in aggregate).
It is important not to overreact to economic newsflow and instead look at the recent weakness in the context of the longer-term trends and structural reform
China is an obvious and ongoing focus. However, it is important not to overreact to economic newsflow and instead look at the recent weakness in the context of the longer-term trends and structural reform. Its strategic and geopolitical importance, both regionally and on the international stage, is only set to grow. This needs to be considered alongside the Chinese authorities’ proven desire to deliver on their structural objectives, something we believe is highly likely to happen given the scale of their resources and political structure.
Regional trade blocs – such as ASEAN in Southeast Asia and Mercosur in South America – are providing insulation by stimulating inter-regional trade and thereby lessening countries’ reliance on the mega-economies of the US and China. The driving forces of a growing and affluent middle class, rising incomes and positive demographics are also still evident in many parts of the emerging market universe.
These dynamics have, in turn, attracted significant portfolio flows across regions, igniting a rally in emerging-market debt and equities in the first part of this year after a difficult 2018 for both asset classes.
The emerging market investor base has also matured, with local domestic savers now making up a far greater proportion
The emerging market investor base has also matured, with local domestic savers now making up a far greater proportion. This has resulted in a steady but decisive move towards local-currency debt finance within emerging markets. This has been partly a conscious effort by both sovereign and corporate issuers to lessen their dependence on dollar funding. It also reflects increasingly liquid local-currency bond markets and investors’ confidence in those markets. Local-debt markets have consequently grown substantially, with a widening band of issuers.
Emerging-market debt has, as a result, become more economically stable and self-contained in recent years, which has in turn attracted interest from larger global institutions where structural allocations have significant upside potential.
As mentioned, however, emerging debt markets still harbour vulnerabilities. One only needs to look at recent events in Turkey and Argentina, where economic and political turmoil has led to ultra-high interest rates in both countries as they attempted to defend their currencies. We saw bouts of this last year, as well as in the last few weeks. Yet, so far, events in those two countries has caused only a minor ripple across other emerging markets. Both provide examples of how the emerging-market debt asset class has matured and strengthened.
Risks remain but opportunities abound
Given a long history of highly correlated moves in some parts of the investment universe, investors should not become complacent. And while the historically close relationship between the dollar and emerging market debt may show signs of changing at times, a sudden spike in the dollar or a continuation of the Fed’s quantitative tightening would still present risks to investors, as would a global recession. Additionally, Argentina and Turkey remain vulnerable, with high debt levels and weak growth.
However, it is more a question of degrees. Our reasoned belief is that the potential risk and impact of contagion across the sector from adverse macro factors has decreased. Relationships may never die, but they can certainly dwindle. And the vacuum created can allow previously affected asset classes to thrive. Emerging-market debt is doing just that.
