EM local currency debt is down nearly 5% since the middle of April, and almost 1% year-to-date. This has caused many nervous investors to question the outlook for the asset class. However the recent weakness in EM FX is due almost entirely to USD strength; we do not expect this drag to be sustained. While we see reasons for more strength in the short term, in the medium term we expect the USD to move sideways.
In our view EM’s domestic fundamentals are sound. GDP growth is strengthening, EM is running a current account surplus, and FX reserves are picking up. EM FX normally performs well in such an environment, leaving investors free to benefit from EM’s attractive yields. However, if one is concerned about sustained USD strength, it can be hedged cheaply and effectively by going long the USD against DM currencies such as the Canadian dollar (CAD). Not only is the outlook for EM still good, but at present it offers outstanding relative value opportunities. Both the Argentinian peso (ARS) and Turkish lira (TRY) have weakened sharply recently, but we are negative on the latter and positive on the former.
In our view the recent weakness in EM FX has been largely due to the strength of the USD. Since the middle of April, however, the USD has strengthened sharply, and EM FX has done what it always does under these circumstances.
In the medium term, the USD tends to be correlated with the global growth cycle, and in particular the difference between growth in the US and the rest of the world. In our view global growth fundamentals remain strong. We expect growth to rebound in the euro area and strengthen in EM ex-China, and we expect the slowdown in China to be gradual. In this environment, we would expect the USD to move sideways.
We believe the underlying fundamentals for EM are sound, and at present the asset class offers outstanding relative value opportunities. On the fundamental side, we believe two key factors are the growth outlook and the balance of payments.
The two major sell-offs across EM as an asset class occurred in 2008 and 2013 – both periods when the countries as a group were running very substantial trade deficits. This is not the case now. The worst-performing emerging currencies (along with sanctions-hit Russia) – have been the only two EM countries with substantial and deteriorating external balances – Turkey and Argentina. For us the external balance is absolutely key, and the current situation, while weaker than a couple of years ago, is still far stronger than the levels associated with broad sell-offs. EM FX tends to be a lot more stable and seldom suffers large drawdowns when the current account is in surplus.
In addition, net capital inflows are still very low by historical standards and we expect them to normalise over time, attracted by EM’s resilient GDP growth and generous yields. If capital inflows rise and FX reserves increase further, we would expect EM FX to perform well.
The growth outlook is also good. Credit growth in EM ex-China fell from 2011 to 2015, but as soon as it started to stabilise in 2016, the credit impulse picked up and EM real GDP growth strengthened to 4%. At present, credit growth is still well below nominal GDP growth, and the debt ratio is falling. As balance sheets improve, we expect credit growth to rise and the positive credit impulse to be a tailwind to demand and GDP growth. In our view this tailwind could last for another two years. EM tends to perform well when growth is strong. We would note here that the picture is somewhat different in China, where credit growth is still strong and the credit: GDP ratio is rising.
In addition to the sound fundamentals for the asset class as a whole, EM local currency debt offers some exceptional relative value opportunities at present. The ARS and TRY have both weakened sharply in recent weeks, but in our view the outlooks for the two currencies are very different.
Both countries have experienced robust demand and deteriorating trade balances, and both countries either needed to hike interest rates, or accept further FX weakness. In Argentina, the incentives are all aligned for further rate hikes and a stable currency. Argentina has relatively large amounts of FX debt, and relatively low levels of domestic credit. Its debt burden will increase if the ARS weakens by too much, and higher domestic interest rates are less likely to plunge the domestic economy into recession because local borrowing levels are low. Argentina’s policymakers have already shown the willingness to do what it takes to defend the ARS, hiking rates by 12.75% over the past fortnight.
EM current account deficits/surpluses
In Turkey, in contrast, domestic households and firms have become increasingly indebted over time, and the political leadership has been firmly against further interest rate hikes. Even when it did hike interest rates in 2017, it cushioned the impact this would have on the domestic economy by introducing a Credit Guarantee Fund, such that credit growth actually increased after the rate hikes. In short, aggregate credit conditions were eased rather than tightened. Turkey would be reluctant to suffer a sharp growth slowdown before the forthcoming election, and as a result its central bank is unlikely to hike rates sufficiently. The adjustment is therefore more likely to occur via TRY weakness.
Our framework for looking at potential crises is based on the point that it is the breadth, not the depth, of a country’s troubles that determines the likelihood of crisis. In Turkey, with high foreign currency debt, vulnerable banking sector, heavy dependence on construction as a driver of growth and divided politics, this creates a vulnerability, but Argentina’s very low domestic debt levels make high interest rates comparatively bearable.