10 March 2020
The spread of the coronavirus has resulted in a major shock to growth across the world, but GAM Investments’ Paul McNamara believes emerging market fundamentals are in reasonable shape and the prospect of a weaker US dollar is likely to represent some relief.
The spread of the coronavirus (Covid-19) and the related collapse in the oil price represent a major shock to the global economy. The oil price move adds disinflation to the deflationary impact of the virus. This is inevitably having repercussions in emerging markets (EM). However, while there are clearly significant risks to EM currencies here, we are substantially more positive on the bonds. Even taking the virus into account, EM fundamentals are in reasonable if unspectacular shape and the prospect of a weaker US dollar is likely to represent some relief.
We felt EM entered 2020 in good shape and global activity data for January does confirm our view of accelerating and widespread global growth, albeit hardly a boom. The EM external account was (and is) in good shape and we saw no significant inflation momentum outside Central Europe.
The spread of the coronavirus has resulted in a major shock to growth across the world and introducing an aggressive quarantine regime in Italy on 8 March marks a sharp escalation of the situation. While EM currencies have sold off year to date, bond performance has been much more mixed, and was actually up 1.6% to 6 March.
The collapse in the oil price has represented a sharp escalation, in particular spreading the scope of the sell off from equities and currencies to credit. Markets are extremely volatile.
The key dynamic within EM local has much more to do with positioning than fundamental exposures. Mexico in particular has been exceptionally hard hit, a result of it being the most popular position within the asset class, although the country is no longer a significant oil exporter and has probably (along with Central Europe) the least exposure to China among the EM majors.
One unusual development in this sell-off is that it is not part of a bigger US dollar strengthening. Since the 20 February lows, the dollar has fallen 6% against the euro and even the lockdown in Lombardy has not reversed any of this move. Again we think technicals play an important role, although the weak US response to the epidemic, and the structural failings of the US healthcare system, will also likely play a role.
Our underlying view is that weaker US growth is good for EM bonds, but very mixed for currencies. We felt Central Europe and Turkey were vulnerable and that Russia and Mexico were well-placed. In fact, under-owned markets like Turkey have significantly outperformed. Meanwhile, frontier countries Ukraine and Pakistan are both likely to be beneficiaries of lower energy prices.
Our concern in the markets is twofold: first the probability of a recession is appreciably higher with the likely consequence of weakness in EM currencies. However, we think the outlook for the US dollar has moved significantly and this may work to the advantage of EM. Unlike 2008 or 2013, EM comes into the selloff with a strong external position. Backdrops such as this only reinforce our view that emerging market debt is a place where an active investment management approach can really make difference.
Source: GAM unless otherwise stated.