8 November 2018
The best value to be had in emerging markets (EM) fixed income is in countries which have suffered this year, so it is no surprise GAM Investments’ Paul McNamara is viewing Turkey with interest, with further tactical opportunities in Brazil and Argentina.
Emerging markets (EM) tend to trade off the global economy, but not in a particularly straightforward way. Historically, they have run into trouble when external balances are out of control, so it is no coincidence that those most in the news this year – Turkey and Argentina – have had the largest external deficits. Turkey has a private sector banking problem very similar to what we saw in Asia in 1997. Many of the banks put the US dollars they borrowed to work domestically, leading to a very fast expansion in the property sector. Property generates local currency revenues which incur foreign currency debt. Once there is an external deficit there is a corresponding need for foreign currency that cannot easily be fulfilled and this leads to a currency crisis. In Argentina it was down to the government: excess borrowing led to a surfeit of imports and thus to currency crisis.
More broadly, the EM external balance has deteriorated from a surplus of about USD 5 billion a month to a deficit of around USD 15 billion a month. Much of that deterioration has occurred in Asia and India in particular. We would not say India has problems on the scale of Turkey or Argentina but it does have a significant adjustment to come, in our view. Imports are running too fast to access domestic demand. The higher oil price does not help either. There are also problems in the non-bank financial system but, to reiterate, we do not see India as a crisis market.
At the moment the big driver of EMs is the credit cycle across most of the region. We think this cycle is coming to the end of a strong phase so we are no longer getting the additional momentum from rising credit growth. Trade wars have also been high on the agenda. So far we are not seeing the trade wars out of the US as a major issue in actual macro terms; neither Asia nor the rest of the EM world really export a significant amount to the US. Taking China as an example, 20% of the economy’s manufacturers export, and 20% of those exports go to the US. So even if we see a wholesale collapse in Chinese exports to the US, we would only be talking around 1% of GDP. Countries like South Korea and Taiwan are slightly more vulnerable, but it is very hard to see a major economic event. While it may be bad for investments it is only bad for growth at the margin.
Looking more closely at China, policy there is again all about credit, with private sector non-financial credit at 240% of GDP. I think there is a general acknowledgement that growth at prior rates cannot continue indefinitely. However the latest attempt to rein in credit growth in China seems to have ended similarly to the other attempts we have seen in the past, and all the indicators we follow show that lending is again picking up there. We expect to start seeing some feed through as a slowdown in the real economy and believe growth could become a problem in Q4 2018 or Q1 next year. At some point China will have to slow fairly dramatically, in our view, but we are not expecting this to be in the next 12 months or so.
In terms of opportunity, we believe the best value to be had is in countries which have been beaten up this year, so we actually feel very positive about Turkey. Domestic demand has absolutely collapsed there: we have seen a 25% drop in imports and the country had a current account surplus in August for only the second time in 10 years. The parallel with Asia in 1997 is extremely strong. There has been a huge currency adjustment, but more importantly there is also a recession, a collapse in domestic demand and imports and the external balance needs to be realigned for the country to get back on the road again. Turkey is by no means safe here, particularly given political policy continues to be eccentric, but the fact remains this is a big manufacturing economy on Europe's doorstep so the prospects are interesting.
We also see tactical opportunities in Brazil and Argentina. Argentina is probably three to four months behind Turkey. It has had the big devaluation and the collapse of domestic demand. It is a much less open economy with a smaller export base. The export base is heavily orientated to soybeans, so unless the soybean price picks up Argentina is not really going to benefit to the same degree.
For Brazil, the markets are looking much more carefully at its economic situation in the wake of the election. Brazil is running real interest rates of 5.5%, which means it cannot afford to run primary fiscal deficits. It has to get spending under control, which will take a huge political effort. That said, some of our team are somewhat sceptical that we are going to get much more than a sentiment-driven bounce in Brazil.
Overall the big driver of EM currencies, though, is the US dollar. We think as long as US growth continues to outpace the rest of the world it is going to be hard to see much of a pull back for the US dollar. However, in our view the recent slippage in US equities is positive for EMs.
For Chinese fixed income markets, index inclusion into the Citi World Government Bond Index (WGBI) is on the agenda for this year, but we do not believe it is sufficient to make a difference: as long as there continues to be pushback from index clients we do not expect to see a huge macro impact on China and believe it is much more likely to impact yields than the currency.
On the broader picture of EMs, the other thing we keep hearing is the huge build-up of debt and the large level of foreign currency, but in our view this demonstrates a lack of perspective. Ratios of EM debt to GDP debt to reserves to exports are generally pretty much in line with historical averages. The debt build-up is entirely due to China, the only part of the EM economy which has added significant amounts of debt either in local or foreign currency relative to GDP or exports or any other metrics.
EMs are going to remain dependent on a favourable global environment. This for us really means a reasonably strong Chinese economy to support the commodity price growth outside the US. Valuations in non-US equity markets are relatively low, so we need a spark of growth from the rest of the world outside the US to get things motoring. I think EMs can best be described as having lots of potential at the moment rather than being a screaming buy.
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